“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 result of a tax deductible expense or exemption which reduces your taxable income. A common deduction on your federal income tax return is personal exemption. An example of how this works: If your income was $50,000 your personal exemption would reduce your taxable income by the 2016 personal exemption of $4,050 so your taxable income would now be $45,950.
What is a Tax Credit?
Unlike tax deductions, tax credits are subtracted from your tax liability (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, child tax credit for one child would reduce that tax 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 10% of your adjusted gross income (7.5% if you are 65 or older)
- State income taxes
- State sales and local tax
- 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 (6,300 if you are single and $12, 600 married filing jointly). 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 $12,600. Let’s further say the total of your itemized deductions is $12,700. Since your itemized deductions exceed your standard deduction by $100, you take the itemized deduction. That’s why it pays to remember additional deductible expenses that may bump you up over the standard deduction and leave you open to additional tax deductions.
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 or if you should itemize or take the standard deduction. TurboTax will ask you simple questions about you and give you the tax deductions and credits you are eligible for based on your answers. TurboTax will also chose the option (standard deduction or itemized deductions) that you are eligible for and gives you the biggest tax refund.
When are you filing your taxes? Have you taken advantage of any tax deductions or credits yet?