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Tax Credit vs. Tax Deduction: How Do They Differ?

A 3D render of the word TAX is cut by a pair of scissors

As every taxpayer knows, taxes can be dreadful. From the hassles of filing to hefty payments, the topic of taxes is not everyone’s cup of tea. However, you can always explore ways to reduce your taxes. It’s both a practical and strategic move that can benefit your finances in the long run, as long as you do it within legal means.

There are two main ways to reduce tax liability: tax credits and tax deductions. Let’s examine the nuances of each and determine which one would be better for lowering expats’ tax liabilities.

What are Tax Credits?

A tax credit is an amount of money you can directly subtract from your income tax to reduce your tax liability. The nature of the credit will determine the tax credit’s value. Individuals or businesses that belong to a particular place, group, or industry may be eligible for certain tax credits. Below are the three basic types of tax credits.

  • Non-refundable

    Non-refundable tax credits are deductions made directly from your tax. They reduce your tax liability to zero. Since they are non-refundable, you automatically lose any excess in your tax credit.

  • Refundable

    Refundable tax credits are paid out to you in full if your credit value exceeds the entire amount of the taxes you owe. Suppose your tax credit lowers your tax liability to less than $0. You’ll be entitled to receive the full amount of the credit as a refund.

    The child tax credit and earned income tax credit (EITC) are among the most well-known refundable tax credits. The child tax credit is an annual tax credit offered to families with qualifying children, while the EITC is available to low- to moderate-income taxpayers who work for an employer or are self-employed and meet certain requirements based on family size and income.

  • Partially refundable

    There is only one partially refundable tax available, and it’s the American Opportunity Tax Credit (AOTC) for post-secondary education students. An eligible student has a maximum annual credit of $2,500. Suppose your federal tax bill is $10,000 and you are entitled to a $2,500 tax credit. That credit cuts your tax bill, leaving your tax due at $7,500.

    On the other hand, if you reduce your tax burden to zero even before using the entire amount of the $2,500 tax credit, up to 40% of the remaining credit can be claimed as a refundable credit.

What are Tax Deductions?

Tax deductions are items you can subtract from your taxable income. With a lower taxable income, your calculated tax liability is likewise reduced.

Your marginal tax bracket is used to determine how much of your tax rate is lowered by tax deductions. This indicates that your tax rate significantly impacts the number of tax deductions you will obtain.

All federal income taxpayers have the option to reduce their taxable income by either taking the standard deduction or itemizing a variety of other deductions.

  • Standard Deductions

    Standard deductions are fixed amounts that the Internal Revenue Services (IRS) used to lower your taxable income. The deductible amount you’re eligible for depends on your filing status, age and whether one or more taxpayers are blind.

    Since standard deductions are a flat amount, anyone can claim them without needing documentation or proof of expenses, which makes it straightforward for most people to claim their standard tax deduction.

  • Itemized Deductions

    Itemized deductions are expenses that you can subtract from your adjusted gross income (AGI). These deductions can vary by taxpayer since everyone has different types of expenses that can be itemized.

    Some of the qualified expenses for itemized tax deductions include:

    • Medical expenses you could not reimburse
    • Charitable gifts
    • Mortgage interest

    Even though it may take more time and paperwork to keep track of allowable expenses and create itemized records for each, itemized deductions can lower your tax burden by a greater amount compared to opting for a standardized deduction. That is especially true if you have more qualifying costs to deduct than the standard deductions that apply to your filing status.

Tax Credit vs. Tax Deduction: What’s the Difference?

In general, tax credits result in greater tax savings than deductions. Unlike credits that directly lower your tax dues, deductions only lower the portion of your income subject to tax.

For instance, a $1,000 tax credit results in a $1,000 reduction in your tax obligation. On the other hand, a $1,000 tax deduction results in a $1,000 reduction in your taxable income—this is the amount of income that is subject to taxation. Therefore, if you fall into the 22% tax bracket, a $1,000 deduction would only lower you taxable income by $220.

Which One is For You?

Doing taxes is a tedious and time-consuming process; however, it is necessary. While getting your tax credits and deductions computed can be a hassle, the reward of having a significant amount of money deducted from your tax bill or tax income is well worth it.

If you’re looking for tax experts who can figure out which option is better for your specific tax situation, Tax Samaritan is here to help. We’re a trusted provider of professional-quality tax resolution services to expats since 1997. Get in touch with us today! Get a Free Tax Quote →

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