The difference between a tax credits and tax deduction 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 and tax deductions.
What is the Difference Between a Tax Credit and Tax Deduction?
There are four key differences between a tax credit and a tax deduction:
- 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.
- The second difference between a tax credit and 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 the standard deduction. You can only choose one of these formats.
- The third difference between a tax credit and tax deduction is their types. Tax credits are either non-refundable or refundable. Tax deductions are available either as an itemized deduction or standard deduction.
- The final main difference between a tax credit and a tax deduction is the possibility of a refund. You may receive a refund if you receive enough refundable tax credits. Tax deductions may not result in a refund unless deductions reduce your income to where you overpay through estimated tax payments or tax withholding.
Is a Tax Deduction or Tax Credit Better?
There are several factors that may make both tax credits or tax deductios 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:
- You may qualify for tax credits regardless of your income or tax liability.
- Tax credits are available as non-refundable and refundable. Non-refundable tax credits can decrease taxes owed to the IRS, and it can bring your tax liability down to zero. However, the IRS will keep the balance after having zero tax liability.
- Refundable tax credits can reduce your tax liability down to zero, and even below zero. When your tax liability is below zero, you’ll receive a refund.
Examples of Tax Credits
Individuals and small businesses alike can qualify for tax credits. Common tax credits include:
- Child and Dependent Care Credit: Allows taxpayers to receive reimbursements for their expenses for the care of qualifying dependents. For the 2021 tax year, the IRS offers this credit as a percentage of up to $8,000 for one dependent’s care expenses or $16,000 for two or more dependents.
- Child Tax Credit: The CTC is offered for child dependents under age 17 before December 31 who live with taxpayers for at least half of the year. The credit is up to $3,000 for children aged six to 17, and up to $3,600 for children younger than six years old.
- Earned Income Tax Credit: A refundable tax credit available to low-income and moderate-income workers.
- Premium Tax Credit: A refundable tax credit available for families and individuals that covers health insurance premiums offered through the Health Insurance Marketplace. This credit comes with income requirements and must filed with Form 8962.
- Qualified Plug-in Electric Drive Vehicle Tax Credit: This tax credit ranges from $2,500 to $7,500 for new vehicles that are all-electric or plug-in models.
- Recovery Rebate Credit: The Recovery Rebate Credit is available for individuals for the 2021 tax year who qualified for but didn’t receive the third Economic Impact Payments.
- Saver’s Credit: The Saver’s Credit is available for taxpayers who make eligible contributions to their employer-sponsored retirement plan or with an IRA. This credit amount will vary according to the adjusted gross income on your Form 1040.
- Work Opportunity Tax Credit: The Work Opportunity Tax Credit is a business credit available for employers that expires in 2025. This credit is for employers who hire employees in 10 targeted groups, and the maximum amount for this credit is 40% of up to $6,000, or up to $2,400.
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:
- Charitable donations
- Interest expense
- Medical and dental expenses
- Miscellaneous deductions
Small business owners can receive tax deductions for different business expenses, such as:
- Charitable contributions
- License and regulatory fees
- Vehicle expenses
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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.