Tax deductions vs. tax credits: How to tell the difference
Tax credits and deductions both reduce your tax bill, but in different ways. Tax credits directly reduce the amount of tax you owe, while tax deductions reduce how much of your income is subject to taxes.
Tax credits and tax deductions may be the most satisfying part of preparing your tax return.
Both reduce your tax bill, but in very different ways.
Tax credits directly reduce the amount of tax you owe, giving you a dollar-for-dollar reduction of your tax liability. A tax credit valued at $1,000, for instance, lowers your tax bill by the corresponding $1,000.
Tax deductions, on the other hand, reduce how much of your income is subject to taxes. Deductions lower your taxable income by the percentage of your highest federal tax bracket. So if you fall into the 25% tax bracket, a $1,000 deduction saves you $250.
The catch to tax credits
Some tax credits are intended to help cover individual costs around buying a first home, adopting a child, child care expenses, home office expenses or caring for an elderly parent.
But these are nonrefundable tax credits. If you don’t owe a lot in taxes to begin with, you don’t get the full value if the credits take your tax bill below zero. In other words, a $600 tax bill combined with a $1,000 credit doesn’t get you a $400 tax refund check.
Other credits are refundable. If you qualify to take refundable tax credits — things like the Earned Income Tax Credit, the Health Coverage Tax Credit, the Making Work Pay Credit, the Child Tax Credit and the Additional Child Tax Credit — the value of the credit goes beyond your tax liability and can result in a refund check.
The IRS lays out specific criteria you must meet to qualify for both nonrefundable and refundable credits.
As you run the tax credit calculations in your return, keep in mind that you must establish the amount of your gross income tax liability before you apply any credits. The credits don’t reduce your taxable income.
But tax deductions do.
The catch to tax deductions
There are two types of tax deductions.
The standard deduction is a one-size-fits-all reduction in the amount of your income that’s subject to tax. You don’t have to do anything to qualify for the standard deduction or provide any documentation.
You can claim the standard deduction on whichever form you file:Form 1040, 1040A or 1040EZ. The standard deduction in 2015 for single filers and married couples filing separately is $6,300; it’s $12,600 for married couples filing jointly. For those filing as heads of household, the standard deduction is $9,250.
But you may be better off opting to use the second type of deduction, the itemized deduction, instead.
Itemizing allows you to total the amount you spent on allowable deductions such as home mortgage interest, medical expenses or charitable donations. If together they exceed the value of the standard deduction, you’ll want to itemize. You’ll need to use the regular 1040 filing form and Schedule A.
Taking the standard deduction or itemized deductions is an either/or situation. You can claim one kind or the other, but not both.
And, just as with tax credits, taking certain deductions requires meeting certain qualifications based on your filing status, current life events and the amount of your income that’s taxable. Be sure you meet IRS criteria to qualify for both tax credits and deductions.
This article first appeared in NerdWallet.