What is the difference between tax deductions and tax credits?

Tax deductions and tax credits have one thing in common. They offer you a benefit. It is essential to differentiate between the two so that you ensure you do not overpay your taxes. Knowing the difference between the two will help you control your taxes and ensure you pay the correct amount when it is time to file.

What is a Tax Deduction?

A tax deduction reduces how much of your income is subject to taxes. The deduction can lower your taxable income by the percentage of your highest federal income tax bracket. There are two approaches to tax deduction: –

• The Standard Deduction – a one size fits all reduction in your income that is subject to tax.
• Itemized Deduction – Enables you to benefit from specific deductions such as medical expenses, mortgage interest and charitable donations.

You must choose either one of these deduction options, as you cannot use both at the same time.

What is a Tax Credit?

This is defined as the dollar-for-dollar reduction of your tax liability. With a credit, you can bring down the total amount of tax that you owe. There are three common tax credits including: –

• Earned Income Credit – This credit is for people working and earning a low to moderate income.
• Savers Tax Credit – This credit assists individuals who meet adjusted gross income requirements to save up for retirement.
• Lifetime Learning Credit – Allows for up to $2000 for education-related expenses. It is dependent on your modified gross income.

It is worth noting that a tax credit may be refundable or non-refundable. When it is refundable, you can reduce your liability to zero and receive any balance on the credit back in the form of a refund. A nonrefundable credit only allows you to reduce your tax liability to zero.

Which is the ideal option between tax deductions and tax credits?

Tax deductions bring down your taxes by lowering the income that you need to pay taxes on. Alternatively, tax credits reduce the total amount of taxes that you owe. By direct comparison, the tax credits seem to be better as they directly reduce the tax owed. You need to consider your marginal tax bracket with tax deductions to calculate the percentage deduction you can receive.

Use these methods to decrease your annual tax burden. With the help of a financial advisor, you can limit your tax liability and find deductions and credits that will work for your business. For assistance with tax preparation and tax advisory services, schedule a discovery call with RCN CPAs.