Your taxable income is reduced by tax deductions, but your tax bill is reduced dollar for dollar by tax credits.
What is a tax credit?
Once you’ve filed your AGI and see that you fit into a particular tax slab, your tax bill is generated. A tax credit is a direct dollar amount that you receive as a discount on your actual tax bill.
Think of it as billing your items at full price at the store, and receiving a flat discount on the actual bill, which results in a lower bill amount.
What is a tax deduction?
The USA has a progressive tax system wherein people of different income groups owe different amounts as tax – the higher your Adjusted Gross Income or AGI – the higher your tax slab and the higher your tax bill. If you’re able to lower your AGI, you lower your eventual tax bill.
When you use tax deductions – you lower the amount of AGI – which reduces the overall amount of tax you’ll end up owing – meaning you’ll receive a lower tax bill because the IRS will understand that, while your income is high, you’ve claimed the appropriate deductions to lower this number. Deductions often result in a lower overall tax bill.
Think of it as using coupons at the store while the cashier is ringing up your purchases, saving a bit here and there, which results in a lower bill amount.
Tax credits
The tax credit will reduce your tax liability dollar-for-dollar, giving you a dollar-for-dollar reduction. When you receive a tax credit worth $1,000, for example, your tax bill will be reduced by $1,000.
Tax deductions
The benefits of tax deductions, on the other hand, are that they reduce the tax burden. As a result of deductions, your taxable income is reduced by the percentage of your federal income tax bracket at the highest. If you fall into the 22% tax bracket, you will save $220 by taking a $1,000 deduction.
| In your opinion, what would be better: | A $10,000 tax deduction… | …or a $10,000 tax credit? |
| Your AGI | $100,000 | $100,000 |
| Less: tax deduction | ($10,000) | |
| Taxable income | $90,000 | $100,000 |
| Tax rate* | 25% | 25% |
| Calculated tax | $22,500 | $25,000 |
| Less: tax credit | ($10,000) | |
| Your tax bill | $22,500 | $15,000 |
The catch to tax credits
It is possible to receive a tax credit that is not refundable. In that case, if your tax bill goes below zero, you won’t receive the full value of the credits if you don’t owe much to begin with. This means that a $600 tax bill paired with a $1,000 nonrefundable credit won’t get you a $400 tax refund.
There are some tax credits that are refundable. In the case of refundable tax credits, such as the earned income credit or the child tax credit, the amount of the credit exceeds your tax liability, and you can receive a refund.
There are certain criteria that must be met in order to qualify for nonrefundable and refundable credits, according to the IRS.
Tax deductions: a big decision
Standard deductions and itemized deductions are two types of tax deduction strategies.
Standard deductions
There is a standard deduction that applies to everyone, reducing the amount of income that is taxable. Standard deductions can be claimed without doing anything or providing any documentation.
On Form 1040, you can claim the standard deduction. If you are filing as an individual or a corporation, the amount varies.
| Filing status | 2021 tax year | 2022 tax year |
| Single | $12,550 | $12,950 |
| Married, filing jointly | $25,100 | $25,900 |
| Married, filing separately | $12,550 | $12,950 |
| Head of household | $18,800 | $19,400 |
Itemizing deductions
Taking advantage of itemizing your deductions allows you to claim home mortgage interest, medical expenses, or charitable donations. You should itemize if the total of your itemized deductions is greater than the standard deduction in order to pay less tax. Schedule A and Form 1040 are used for regular tax returns.
There is no either/or situation when it comes to taking the standard deduction or itemized deductions. The two are not compatible. One or the other must be chosen.
Like tax credits, some deductions require meeting certain requirements based on your filing status, your current life circumstances, and your taxable income. In order to qualify for both tax deductions and credits, make sure you comply with IRS requirements.
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