What's the difference between tax deductions and tax credits?

Saving money is worth the paperwork.

Tax season can be stressful, but saving money always helps. To reduce your tax bill, you need to take advantage of as many tax deductions and tax credits as possible. But what’s the difference?

Tax deductions reduce how much of your income gets taxed, and tax credits directly reduce the amount you owe. And with a little finesse, you can find every tax break you qualify for.

The basics

• Tax credits and tax deductions both reduce your tax liability, but in different ways
• Tax deductions subtract from the income used to calculate tax liability
• Tax credits are applied directly to the tax liability
• Tax credits save money a little bit more directly, but you should be using both

What are tax deductions?

Taking a tax deduction saves you money by reducing the income used to calculate your tax liability. Basically, you get taxed as if your income was lower than it really is.

Deductions are based on your expenses, although not every expense qualifies.

Above-the-line deductions

The first deductions you can take are called above-the-line deductions or adjustments to income. They’re the first things subtracted from your gross income, the sum total of all earnings before any deductions or taxes. Examples of qualifying expenses include student loan interest, contributions to Traditional IRAs, and payments to health savings accounts.

Once the above-the-line deductions are applied, what’s left is your adjusted gross income or AGI. Your AGI is important for, among many other things, determining which itemized deductions you qualify for.

Itemized vs standard deductions

Once you’ve arrived at your AGI, you have two options with your below-the-line deductions: taking the standard deduction or taking itemized deductions.

Every taxpayer qualifies for the standard deduction, which knocks one large chunk off your taxable income. The amount differs based on filing status (single, married, head of household, etc) and for many taxpayers, it’s a much bigger discount than they’d be able to get itemizing. It’s also much faster.

Itemized deductions are taken one-by-one based on certain qualifying expenses, like charitable donations or home office costs. Your deductible expenses are added up to arrive at the total deduction you can take. It’s more complicated than the standard deduction, and not all taxpayers have enough of the right kind of expenses to make it worthwhile. For some people, however, itemized deductions can far outweigh the standard deduction.

You cannot take both types of below-the-line deductions (though you can take the standard deduction alongside any above-the-line deductions) which means you should only be itemizing your deductions if the total amount would exceed the standard deduction. The average taxpayer is more likely to benefit from taking the standard deduction, especially after it was nearly doubled in 2018 with the passage of the Tax Cuts and Jobs Act. High income taxpayers, business owners, and anyone else with particularly high spending are more likely to benefit from itemized deductions.

What are tax credits?

Unlike tax deductions, which reduce the income used to calculate your tax liability, a tax credit is simply a direct, dollar-for-dollar subtraction from your tax liability itself, after it’s been calculated from your income.

Nonrefundable tax credits

If you qualify for more tax credits than you actually have in tax liability, one of two things can happen.

Some tax credits will allow you to subtract past $0 and end up with a refund instead of a bill. Common examples of this include the Earned Income Tax Credit and the Child Tax Credit.

Other tax credits – called “nonrefundable” tax credits – can’t bring your liability any lower than $0.

Which one is better?

Tax credits hit a little harder than tax deductions, thanks to how the math shakes out. All else being equal, applying a credit directly to the tax liability, rather than taking a deduction from your taxable income, gets you the bigger discount.

It’s worth thinking about, since you can’t usually take a deduction and a credit on the same expense – for example, taking both the tuition and fees deduction and the lifetime learning credit. One common strategy is taking the standard deduction and then applying whatever tax credits you qualify for.

Everyone’s situation is going to be different, and if you’ve got something complicated in your financials, like a small business, it’s a good idea to have a qualified tax accountant take a crack at it.

Are there limits?

Individual types of deductions and credits, like for medical expenses or education costs, have limits, usually based on a percentage of your AGI. However, there’s no limit on the total amount you can save in deductions and credits. Take advantage of everything you qualify for.

Things to keep in mind

• The Earned Income Tax Credit (EITC) is known for occasionally delaying any refund you might qualify for, and other deductions and credits may do the same.
• If you’re married, you and your spouse will be choosing between the standard and itemized deductions together. No mixing and matching. This applies whether you’re filing jointly or separately.
• Itemizing requires a lot of proof, so make sure you’re doing your paperwork. You don’t want to give the IRS any reason to take a closer look at your tax return, which can be costly and time consuming.

How to claim deductions and credits

Individual tax returns are filed with Form 1040, which includes instructions for deductions and credits. You may also need to include attachments, like Schedule A if you’re itemizing or Schedule EIC for the Earned Income Tax Credit.

It can get a little complicated, but a qualified CPA or other tax professional can make sure everything is nice and polished.

Bottom line

You want to pay the lowest amount in taxes that you can, and to make that happen, you will need to think about deductions and credits.

Tax deductions are subtracted from taxable income, and you can choose between itemizing your expenses or just taking the standard deduction. Tax credits are subtracted from your tax bill itself.

Like many things involving the IRS, figuring out how to make optimal use of deductions and credits can be tricky. To keep things simple, give DiMercurio Advisors a call. We’ll take care of the tax stuff so you can focus on everything else.