What is the difference between a tax deduction and a tax credit?
If the terms tax credit and tax deduction are new to you, it may seem like they are two words for the same thing. While both give you a break on taxes, they do it in a very different way.
When determining the benefit of a tax deduction vs tax credit, it’s essential to understand the difference between the two.
Plus, 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.
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 Child 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.
Tax credit vs deduction – An example
Generally, tax credits tend to be more valuable compared to deductions. That’s because of the dollar-for-dollar reduction mentioned earlier. Here’s a simplified example to make things easy. Let’s say a credit and a deduction that are both valued at $1,000 and that your tax liability is $3,000.
With the $1,000 tax credit, your tax bill is reduced to $2,000. With a tax deduction, it lowers your taxable income. So, if you’re in the 12% tax bracket, that $1,000 deduction takes $120 off of your taxable income (not your tax bill).
One final note: You can choose any of the options you qualify for. The best one for you depends on your overall tax situation.
Get help with claiming tax credits and deductions
If you’re looking for guidance filing your taxes, 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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