“Just write it off.”
“Go ahead and deduct it.”
“I think there’s a tax credit for that.”
Although you might have heard or even uttered one of the sentences above, have you ever wondered or sought to understand its true meaning? While both tax deductions and tax credits can save you a significant amount of money on your taxes, they work in significantly different ways.
What is a Tax Deduction?
A tax deduction is a qualifying expense which reduces your taxable income. A common deduction on your federal income tax return (Form 1040) is for state income taxes you pay. An example of how this works: Say, when considering all of your income and deductions except for state income taxes, you have $35,000 of taxable income. Furthermore, let’s assume you paid $1,000 in state income taxes for the year. By deducting the $1,000 in state income taxes, your new taxable income is $34,000.
What is a Tax Credit?
Unlike tax deductions, those eligible for tax credits subtract the amount of the credits from their tax liabilities (not taxable income). A common tax credit is the child tax credit. If you have a qualifying child, you can take a credit of up to $1,000 per child against your tax liability. If, besides the child tax credit, you would otherwise have a total federal income tax liability of $2,500, a one child tax credit would reduce that liability to $1,500.
Is a Tax Deduction Better Than a Tax Credit? Is a Tax Credit Better Than a Tax Deduction?
If you were ever faced with a hypothetical choice between a $100 tax deduction and a $100 tax credit, you would want the credit. Unlike a tax deduction, a $100 tax credit reduces your tax dollar-for-dollar ($100). On the other hand, a tax deduction reduces your taxable income by $100. The resulting amount of tax you save depends on your marginal tax bracket (in everyday language: your tax bracket). If you are in the 25% tax bracket, a $100 tax deduction reduces your taxes by $25.
Itemized Deductions vs. Standard Deductions
Just about everyone qualifies for the standard deduction. Although based on your filing status (e.g., single, married filing jointly, married filing separately, or head of household), all people with the same filing status receive the same standard deduction amount. (The only exceptions are for the elderly, disabled, or blind – they receive a somewhat higher standard deduction).
By contrast, itemized deductions are numerous and their amounts vary by individual. Common itemized deductions include:
- Certain medical and dental expenses above a certain threshold
- State income taxes
- Property taxes
- Charitable contributions
- Mortgage interest
There’s a bit of a hitch with itemized deductions, however. You can only benefit from itemized deductions to the extent they exceed your standard deduction. Said another way, each taxpayer is permitted to take the higher of their standard or itemized deductions – but not both.
Say you are married and filing jointly. In such a case, your standard deduction is $11,600. Let’s further say the total of your itemized deductions is $11,700. Since your itemized deductions exceed your standard deduction by $100, you take the itemized deduction. Further, if you are in the 25% bracket, your itemized deductions save you $25 more vs. simply taking the standard deduction.
On the other hand, had your itemized deductions totaled any amount less than the standard deduction you qualify for, you wouldn’t bother taking the itemized deduction – you’d just take the standard.
Whether an expense qualifies for an income tax deduction or tax credit, be sure to take maximum advantage – both lower the taxes you’ll pay. Don’t worry about trying to figure out which ones you should take, TurboTax will easily guide you and get you the tax refund you deserve.
When are you filing your taxes? Have you taken advantage of any tax deductions or credits yet?