It’s tax filing season and millions of Americans are seeking advice and scouring the internet for the best ways to cut their tax bills.
As taxpayers research all of the potential ways to save money, they’re sure to come across two similar terms over and over again — tax credit and tax deduction.
While both tax credits and deductions can reduce the amount you owe to the federal government in taxes, they don’t operate exactly the same.
What is a tax credit?
A tax credit is an incentive that allows taxpayers to subtract a given amount from the total tax bill they owe the IRS for the year. These credits are given in an effort to encourage people to support the economy by spending money on public goods like housing and childcare. This is also known as a dollar-for-dollar reduction on your tax obligation.
Here’s an example of how claiming a tax credit works. Let’s say you owe the IRS $18,000 as your tax obligation for the money you earned last year. If you qualify to claim a $1,000 credit, your tax bill will be lowered from $18,000 to $17,000. Assuming you already paid the IRS $18,000 (or more) throughout the year via payroll withholding, the IRS would now owe you a refund.
Tax credits come in three varieties – nonrefundable credits, refundable credits and partially refundable credits. Here’s a breakdown of how these three types of credits work, along with examples of each:
Nonrefundable tax credits
A nonrefundable tax credit means you can get a refund up to the amount you owe. So, if you owed $1,500 in taxes and were eligible to receive a $2,000 credit, you would only be eligible to use $1,500 of that credit so that your tax bill is reduced to zero. Any leftover credit amount is forfeited and will not increase the size of your refund check.
Examples of nonrefundable credits currently include:
- Adoption tax credit
- Elderly and disabled tax credit
Refundable tax credits
Refundable credits are treated as though they were tax payments you made throughout the year (just like the money an employer withholds from your paycheck and sends into the IRS on your behalf).
If a refundable credit adds up to more than your total tax obligation, the IRS will still send you the difference in the form of a tax refund.
Examples of refundable tax credits currently include:
- Earned income tax credit
- Premium tax credit (Affordable Care Act)
- Health coverage tax credit
Partially refundable tax credits
A partially refundable tax credit means that the credit can be used to bring your tax obligation down to zero. From there, you may be eligible to receive a refund on a portion of the remaining credit.
For example, the American Opportunity Credit, designed to help families pay for higher education expenses, may be worth up to $2,500 if you are an eligible student (or have a dependent who qualifies as an eligible student). If the tax credit is more than the taxes you owe, 40 percent of the leftover amount (up to $1,000 max) can be issued as a refund.
What is a tax deduction?
Unlike credits, tax deductions are not subtracted from the amount of taxes you owe the federal government. Rather, a deduction lowers how much of your income is subject to taxes in the first place. In the eyes of the IRS, if you qualify for a deduction it’s as if you earned less money.
Here’s an example of how claiming a deduction on your taxes works. If your income puts you in the 24 percent tax bracket, a deduction of $1,000 would save you $240 on your tax obligation.
Another way to look at it is this. Your $1,000 deduction essentially has the same value a $240 tax credit would carry (in this specific example).
Of course, how much a deduction actually saves you will largely depend upon your federal income tax bracket. Justin Pritchard, CFP and founder of ApproachFP.com, a fee-only financial advisory practice based in Montrose, Colorado, explains that since “deductions reduce what you report as income, the dollar value you receive depends upon your tax rates.”
Which is better?
Anything that reduces your tax bill is a good thing, at least from a taxpayer’s point of view. Yet when it comes to tax credits vs. deductions, credits outshine deductions because of how much money they can save you.
Megan Brinsfield, CPA and director of financial planning at Motley Fool Wealth Management, explains that in the battle of credits versus deductions, “credits win every time because they are a dollar-for-dollar reduction of your tax bill.” On the other hand, Brinsfield continues, “deductions will reduce your overall income before applying to your tax rate.”
Debbie Todd, CPA and president of iCompass Compliance Solutions, agrees that credits are a more valuable way to reduce your taxes. “While any tax deduction is better than no deduction, a tax credit will put more real dollars in your pocket,” she said.