The difference between tax credits and tax deductions is something that can often be misunderstood. Their purposes have a similar end result, and both can play a significant role when you file taxes (namely, to save you money as a taxpayer), which makes knowing their differences crucial. Here are the fundamental differences between tax credits vs tax deductions.
What is the Difference Between a Tax Credit vs. Tax Deduction?
There are four key differences between a tax credit vs. tax deduction:
How they reduce the amount of tax owed
Both tax credits and tax deductions reduce the amount owed but in different ways. Tax credits reduce the amount of tax owed by lowering your tax liability or the amount owed. Tax deductions will reduce the amount of income that’s taxable.
How many of each you can claim
The second difference between a tax credit and a tax deduction is how many of each you can claim. You can claim multiple tax credits as long as you’re eligible for them. Tax deductions are available in two formats: itemized deductions and standard deductions. You can only choose one of these formats.
Their types
The third difference between a tax credit and a tax deduction is their types. Tax credits are either non-refundable or refundable. Tax deductions are available either as itemized deductions or the standard deduction.
Possibility of a refund
The final difference between a tax credit and a tax deduction is the possibility of a refund. Tax deductions lower your taxable income and can lead to a refund if they reduce your liability enough that you've overpaid through withholding or estimated tax payments. Tax credits, on the other hand, directly decrease your tax liability. Some are "refundable," meaning they can result in a refund if the credit exceeds your total tax liability, regardless of your tax payments throughout the year.
Is a Tax Deduction or Tax Credit Better?
There are several factors that may make both tax credits and tax deductions considerable. Tax credits and tax deductions are both helpful, but there’s one that is better for taxpayers.
For tax deductions, you have the option of taking an itemized deduction or a standard deduction. However, you can’t take both deductions in the same tax year.
Itemizing deductions allows you to claim specific deductions, but you’ll need to complete a separate tax form. The standard deduction is another choice that may work for you. While you don’t need to complete another tax form, the amount you’ll receive for a standard deduction varies based on your filing status.
Tax credits are the more favorable option because they directly reduce the amount of taxes you owe. Tax deductions reduce your taxable income but this is largely affected by marginal tax brackets.
Here are a few additional reasons why tax credits are more beneficial:
Examples of Tax Credits
Individuals and small businesses alike can qualify for tax credits. Common tax credits include:
Examples of Tax Deductions
Whether you’re an individual or part of a small business, you also qualify for tax deductions. There are two ways of receiving a tax deduction. You can choose a standard deduction, which is a fixed amount, to reduce your taxable income. Or, you can itemize deductions on your tax return. Some deductions you can itemize include:
Small business owners can receive tax deductions for different business expenses, such as:
Check out this helpful tax deduction checklist for more information.
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Figuring out which tax deductions and tax credits you apply for is the best way to lower your bill this tax season. However, if you miss deductions or credits you qualify for, you’ll likely leave money on the table and overpay taxes to the IRS. When it’s time for you to file your taxes, work with the business tax professionals at 1-800Accountant to lower your tax bill.
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This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. 1-800Accountant assumes no liability for actions taken in reliance upon the information contained herein.