What is the difference between a tax deduction and a tax credit?
Tax Credit vs Tax Deduction
When determining the benefit of a tax deduction vs tax credit, it’s essential to understand the difference between the two. Let’s define each:
What is a Tax Credit?
A tax credit is a dollar-for-dollar reduction of the income tax owed. A tax credit directly decreases the amount of tax you owe . Common credits include the Earned Income Credit, American Opportunity Tax Credit, and the Savers Tax Credit.
A credit can be nonrefundable or refundable. A nonrefundable credit lets you reduce your tax liability to zero (0). A refundable credit can also reduce your liability to zero (0) but there is an added benefit. If there’s any amount leftover from your refundable credit after reducing your tax to zero, you get the balance of the credit back as a refund. The Earned Income Tax Credit (EITC) is an example of a refundable credit.
What is a Tax Deduction?
Tax deduction lowers a person’s tax liability by reducing their taxable income Because a deduction lowers your taxable income, it lowers the amount of tax you owe, but by decreasing your taxable income — not by directly lowering your tax. The benefit of a tax deduction depends on your tax rate. Here are some commonly overlooked tax deductions.
Deductions and credits can be limited by your income so choosing one over the other can be tricky, A tax professional can help you sort through the complexity and choose whether to claim a credit, deduction, or both if eligible.
The Difference Between Tax Credit and Tax Deduction – An Example
Say, for example, that you or one of your dependents is in college. There are several options to get a credit or a deduction for tuition paid.
Tuition of $10,000 can reduce your total tax up to $2,500 using the American opportunity credit, which can reduce your total taxes due up to $2,500. The American opportunity credit is partially refundable, so even if you don’t owe any tax, you could receive a refund of up to $1,000.
Another credit option for education expenses is the lifetime learning credit. This credit can result in a reduction in tax up to $2,000. The lifetime learning credit is nonrefundable, so if you don’t have any taxable income or your tax liability is reduced to zero, it would not create a refund.
Taxpayers could also choose the tuition and fees deduction, which can reduce your taxable income by up to $4,000. If you’re in the 22% tax bracket, a $4,000 deduction lowers your taxes by $880. A deduction can only lower your taxable income and the tax rate that is used to calculate your tax. This can result in a larger refund of your withholding. A credit reduces your tax giving you a larger refund of your withholding, but certain tax credits can give you a refund even if you have no withholding.
You can choose any of the options you qualify for. The best one for you depends on your overall tax situation.
Get More Help
If you’re looking for more hands-on guidance, H&R Block can help. Whether you make an appointment with one of our knowledgeable tax pros or choose one of our online tax filing products, you can count on H&R Block to help you get back the most money possible.
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