How Are Tax Deductions And Tax Credits Different?
When it comes to preparing your taxes, the idea of tax deductions and tax credits can be music to any taxpayer’s ears. That’s because both lower the amount of taxes owed to the government. While they’re both worth getting excited over, it’s important to understand the fundamental differences between these two terms.
What Are Tax Deductions?
Tax deductions are used to reduce the amount of income that’s eligible to be taxed. By reducing this amount, you reduce the amount of tax owed. In addition, your income may fall into a lower tax bracket, meaning you’re subject to pay a lesser tax percentage. There are typically two types of tax deductions: above-the-line deductions and below-the-line deductions. This line refers to adjusted gross income (AGI) on your income tax return.
Above-the-line deductions are used to reduce your AGI, which can qualify you for certain itemized deductions and tax credits. AGI is determined by subtracting above-the-line deductions from your gross income. This lower AGI can then allow you to claim important tax credits or deductions that may be dependent on income level. Common above-the-line deductions include:
- Business expenses
- Self-employment tax
- Health Savings Account (HSA) contributions
- Deductible contributions to IRA and certain employer retirement plans
Below-the-line deductions are subtracted from your AGI to help lower your taxable income. Taxpayers choose between using itemized deductions or standard deductions. Common types of itemized deductions include:
- Itemized deductions (charity, property tax, mortgage interest)
While people are welcome to add each deduction up separately on their taxes (i.e., itemize them), most will opt for the standard deduction set by the IRS. Here are the standard deduction amounts for 2022:
- Single or married but filing separately: $12,950
- Married and filing jointly or qualifying widow(er): $25,900
- Head of household: $19,400
It is common to use a standard deduction because, in most cases, an itemized amount won’t exceed the IRS’s standard deduction amounts.
What Are Tax Credits?
Simply put, tax credits are reductions on the amount of actual tax owed. Tax credits in no way affect your tax bracket or taxable income but are reductions that come after the fact; i.e., after you’ve determined how much you owe to the government. Here are a few common tax credits:
- Child and Dependent Care Credit
- Lifetime Learning Credit
- Adoption Credit
- Residential Energy Tax Credit
Tax credits are typically either refundable or non-refundable. Depending on the type of credit, this will affect how much you’ll receive back on your tax refund. Refundable tax credits are tax credits that allow you to be refunded the remaining, unused portion of a credit. Alternatively, non-refundable tax credits will only cover the taxes you owe, up to the credit’s limit.
Tax credits and tax deductions can both greatly benefit taxpayers, especially when they work in tandem. Familiarizing yourself with the difference between these two tax terms gives you a great place to start understanding which deductions and credits you and your spouse may be eligible for in the upcoming tax year. Be sure to check in with your financial planner – an understanding of your taxes owed for any given year will help guide many of your financial decisions.