Tax Credits vs Tax Deductions

They may be interchangeable if you’re unfamiliar with the terms tax credit and tax deduction. Both provide tax breaks but in very different ways. Understanding the distinction between a tax deduction and a tax credit is critical when considering the benefit of one over the other.

While these may appear to be the same, they are two distinct procedures. A tax credit is a dollar-for-dollar decrease in the tax you owe, whereas a tax deduction reduces your taxable income for the year. Both, however, can help you save some money.

What is a Tax Deduction?

Tax deductions are sums you deduct from your income before computing your federal taxes. Include your wages and other income on the first page of your tax return, Form 1040. You can take deductions further down the page to minimize your gross taxable income.

Most taxpayers will claim the standard deduction, a fixed amount set by the IRS every year. Tax deductions come in two types: above-the-line and below-the-line.

What are the Above Line Deductions? 

Above-the-line deductions are expenses used to compute your adjusted gross income (AGI). To calculate your AGI, combine and remove these deductions from your gross taxable income. 

Take in mind that these deductions are not the same as the ones you itemized. Itemized deductions (including the standard deduction) are monetary amounts deducted from your AGI.

Use Schedule 1 to report above-the-line deductions and compute the total. Subsequently, the amount from Schedule 1 line 10 is moved to Line 8 of Form 1040 or Form 1040-SR.

• Student loan interest, which covers up to $2,500 in interest on both federal and private student loans
• Contributions to a regular IRA or 401(k), as well as health savings and flexible spending accounts, can be made before taxes.

• Capital Losses

Below the Line Deductions

Everyone does not have above-the-line deductions, but every taxpayer is eligible for a below-the-line deduction. These type of deductions are either the standard deduction or the total amount of your itemized deductions, whichever you prefer. These deductions appear on Line 12 of the 1040 and are subtracted from the adjusted gross income on Line 11.

When itemizing, you can potentially take the following below-the-line deductions (subject to limitations):

• Mortgage Interest
• Medical expenses exceed 7.5% of AGI and charitable contributions.
• Gambling Losses
• State and local taxes

Understanding Tax Credits

A tax credit is an exact dollar reduction in the amount of income tax due. It lowers your tax obligation right away. The Earned Income Tax Credit, the Child Tax Credit, and the American Opportunity Tax Credit are examples of common credits.

A credit may be nonrefundable or refundable. A nonrefundable credit reduces your tax liability to zero. A refundable credit can likewise reduce your liabilities to zero but has an additional benefit. If any amount is left over from your refundable credit after reducing your tax to zero, you will get a refund for the balance amount. 

Tax Credit vs. Tax Deduction: Which One Is Better?

Tax credits are often thought to be superior to tax deductions because they immediately reduce the amount of tax owed. A tax deduction affects your tax liability according to your marginal tax bracket. For example, if you’re in the 10% tax bracket, a $1,000 deduction will only cut your taxable income by $100 (0.10 x $1,000). Still, if you’re eligible for a tax credit and a deduction for the same expenses, analyzing the figures might help you determine which would provide the most tax savings.

Eligibility factors

It would help if you normally met certain eligibility conditions or criteria to qualify for a tax credit. For example, the child tax credit is only available to taxpayers with a qualified kid under 17 at the end of the year. Deductions are often more widely used and have fewer restrictions. However, if you choose to itemize deductions, you may be required to supply additional documents.

Final Notes 

Tax credits and deductions reduce your taxes but in different ways. A tax credit is a dollar-for-dollar reduction in the amount owed, but a tax deduction reduces your taxable income, giving you a reduced tax bill. If you’re unsure what deductions you could be eligible for, consult a tax specialist, such as a financial advisor.