If you want to reduce your taxes, it's important to understand credits and deductions.
It makes sense that people would conflate the two terms — after all, they both help you save money at tax time. However, "they reduce your tax bill in different ways," explains Susan Allen, senior manager for tax practice and ethics at the AICPA.
Here's what you need to know about how credits and deductions work.
Tax credits directly reduce your tax bill, Allen says. If you have a $1,000 tax credit, that means you no longer owe $1,000 in taxes. The more tax credits you are eligible to receive, the lower your overall tax burden becomes.
Credits do have their limits, however. Many, like the Lifetime Learning Credit, are "nonrefundable." So if you owe the IRS $600, and you have a $1,000 nonrefundable tax credit, you won't get the full value of that credit. Your tax bill just goes to zero.
Other credits are "refundable" in whole or in part, which can potentially result in a tax refund. If you owe the IRS $600 and have a $1,000 refundable tax credit, you could receive the remaining $400 back as a tax refund. The Earned Income Tax Credit is an example of a refundable tax credit.
Video by Stephen Parkhurst
Tax deductions are less valuable than credits. They reduce how much of your income is taxed, Allen says — so their value depends on your tax rate.
Deductions automatically apply to your highest income tax bracket. Claim enough of them and you can drop into a lower bracket.
Let's say you earned $55,000 in 2019, which puts you in the 22% bracket. If you're eligible for $1,000 in tax deductions, that reduces your taxable income by $1,000, to $54,000. That's $1,000 that is not taxed at your top tax rate of 22%, so you would save $220.
But for someone in the 10% bracket, that $1,000 in deductions would only be worth $100.
There are two categories of deductions:
- "Below-the-line" deductions. Taxpayers can choose between taking a "standard deduction" (currently $12,200 for single filers and $24,400 for married filers), or claiming "itemized deductions," which requires tallying which below-the-line deductions you're eligible for. You can only claim these below-the-line breaks — which include mortgage interest, medical expenses, and charitable donations, among others — if you itemize.
- "Above-the-line" deductions. These breaks are available even if you take the standard deduction. Above the line, "if you have it, you get it," Tim Steffen, a CPA who is now an advisor education consultant with PIMCO, told Grow last year. For example, if you meet the qualifications to claim the breaks including moving expenses, IRA contributions or student loan interest paid, you can do so.
Figuring out which credits and deductions you might qualify for isn't always straightforward. If possible, talk to a tax professional to make sure you're not missing a valuable tax break.
More from Grow: