Tax Credits Vs. Tax Deductions: What You Need To Know

By Michael Diaz. May 7th 2016

Most people know that taking advantage of tax credits and tax deductions is crucial to saving money during tax season. However, a surprising amount of taxpayers do not understand the difference between the two types of tax breaks. Understanding how tax credits and tax deductions differ is important and can end up saving you from paying more than you should in taxes. Read on to find out how the two tax breaks differ.

How Your Income Tax Is Calculated

Before defining tax deductions and tax credits, it will be helpful to look at a brief explanation of how your income tax is calculated. This will help to frame the differences between the two types of tax breaks. Keep in mind that this is a very high level explanation. You should consult a tax professional or the IRS for a more detailed explanation of how your income tax burden is calculated.

The IRS and your local and state governments calculate how much you will pay in income taxes by taking a percentage of your taxable income. Your taxable income is mainly comprised of the wages that you earn from working and any income that your get from your investment portfolio. The percentage that the IRS takes from your taxable income will depend on which tax bracket you fall into.

For example, if you are filing as single and your 2011 annual taxable income was $100,000, you would fall into the 28 percent tax bracket. Therefore, the IRS will calculate your tax bill based on your taxable income and the 28 percent tax rate. (For more information on the current IRS tax schedules, see Federal Individual Income Tax Rate Schedules For 2011.)

Tax Deductions Reduce Your Taxable Income Before Your Tax Bill Is Calculated

A tax deduction allows you to reduce your taxable income by some amount before your tax bill is calculated. Since your taxable income is used to calculate how much you will have to pay in taxes, reducing your taxable income helps to reduce your overall tax bill.

For example, if your taxable income for the year was $100,000 and you claimed a tax deduction of $20,000, your new taxable income would be $80,000. After taking the deduction into account, the IRS will calculate your tax bill by taking a percentage of $80,000 instead of $100,000. This will lower your tax bill.

If you take enough tax deductions, you may be able to reduce your taxable income by enough to move to a lower tax bracket which will lower the percentage that the IRS uses to calculate your tax bill.  

It is important to note that most deductions must be itemized which requires extra work when filling out your tax return. However, this is not an issue if you pay someone to do your taxes. (To learn more about itemizing your deductions, see Standard Or Itemized Deductions: Which Should You Take?)

Tax Credits Reduce Your Tax Burden After Your Tax Bill Is Calculated

A tax credit allows you to reduce your tax liability by some amount after your tax bill is calculated. After looking at your taxable income and finding out what percentage you will be taxed, the IRS will compute your tax bill. Unlike deductions which reduce the size of your taxable income, tax credits allow you to reduce the size of your actual tax bill.

For example, if the IRS determines that your tax bill is $10,000 but you claim a tax credit of $5,000, your new tax bill will be $5,000.

Two Types Of Tax Credits

There are two types of tax credits:

  • Refundable: These tax credits allow for the possibility of receiving a refund from the IRS. For example, if your tax bill is $500 but you have a refundable tax credit for $600, the government will cut you a check for $100. The earned income credit and the lifetime learning credit are two examples of refundable credits. (For more information on these two credits, see Guidelines On How To Qualify For The Earned Income Tax Credit and 4 Tax Breaks For College Students.)
  • Non-Refundable: These credits can only bring your tax bill to zero. If the credit in the example above was non-refundable, you would not have to pay any taxes but you would not receive a check for the difference. The child and dependent care tax credit is an example of a non-refundable tax credit.

Deductions And Credits Are Not Mutually Exclusive

You are allowed to take both tax credits and deductions. Therefore, you can lower your taxable income using deductions and then lower your tax bill by using credits. However, there are rules and eligibility requirements that apply to both types of tax breaks. In some cases, you may have to decide between the two options. You might want to consider consulting with a tax professional to find out which credits and deductions you are eligible for. You can also check out the IRS website for more information.

Knowing the difference between tax credits and deductions is important, especially if you have to choose between the two. Do your homework ahead of time and you will be prepared when tax season rolls around.    

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