What is the difference between a tax credit and a tax deduction?
You may have heard one or more of these sentences, but have you ever thought about what they mean? Both deductions and credits are great ways to save money on taxes. However, they work in very different ways.
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For more information on tax credits and deductions, see the following.
What’s a Tax Deduction?
Tax deductions result from tax-deductible expenses or exemptions that reduce your taxable income. The standard deduction is a common deduction on your federal income taxes return. This is how it works: If you had $50,000 in income, your standard deduction (single or married filing separately) would reduce your taxable earnings by the 2021 standard deduction, $12,550. Your taxable income would then be $37,450.
What’s a Tax Credit?
Tax credits, unlike tax deductions, are subtracted from taxes owed (not taxable income). The Child Tax Credit is common. The Child Tax Credit was extended in the tax year 2021. You can claim a credit of up to $3600 per child for children under 6 and $3,000 per child for 6-17 years old, depending on your income.
Is a tax deduction better than a tax credit? Is a tax credit better than a tax deduction?
Most people would prefer to get the credit if faced with a $100 deduction or a $100 credit. Unlike a deduction, a $100 credit reduces your tax dollar-for-dollar ($100). A deduction, on the other hand, reduces your taxable income by 100 percent. Your marginal tax bracket is what determines how much tax you can save. A $100 deduction will reduce your taxes by $24 if you are in the 24% tax bracket. A $100 credit would lower your taxes by $100.
Itemized Vs. Standard Deductions
The standard deduction is available to almost everyone. The amount you receive will vary depending on whether you are single, married, filing jointly, filing separately or head of household. However, everyone with the same filing status gets the standard deduction.
However, itemized deductions can be numerous, and their amounts may vary depending on who they are and what deductions they can claim. It is common for people to itemize:
- Some medical or dental expenses that exceed 7.5% of your adjusted income
- Income taxes in the state
- Sales tax and local taxes in the state
- Property taxes
- Charitable donations
- Hypothecary interest
However, there is a catch to being eligible for itemized deductions. Only the amount they exceed your standard deduction ($12550 for singles and $25,100 for married filing jointly in the tax year 2021) is eligible to benefit. In other words, taxpayers can choose to take standard or itemized deductions. But not both.
Let’s say you are married and filing jointly. Your standard deduction in such cases is $25,100. Let’s say that your total itemized deductions are $26,500. Your itemized deductions are higher than your standard deduction by $1.400, so you will most likely choose to take the itemized deduction. It is important to keep track and record any additional tax-deductible expenses. This will allow you to take advantage of other deductions like charitable contributions.
However, if you have itemized deductions that total less than the standard deduction, you won’t bother itemizing and will take the standard deduction. TurboTax and the IRS estimated that 90% of taxpayers now use the standard deduction. This is because it has nearly doubled taxpayers’ tax liability, and some itemized deductions have been reduced or eliminated. About 70% of taxpayers claimed standard deductions before tax reform.