If you’re relatively new to filing taxes each year, chances are you’ve heard some terms that may seem interchangeable in the beginning. Two of the most commonly confused terms are “tax credit” and “tax deduction.” Here’s a look at both terms and how they’re different from one another.
Unlike tax deductions (or “write-offs” as they’re common known), a tax credit doesn’t reduce your overall taxable income. It reduces your overall tax liability instead.
There are two types of tax credits: refundable and non-refundable. A refundable tax credit is one that will both reduce your overall tax liability and be returned to you in the form of a refund. The Earned Income Tax Credit (EITC) is an example of a refundable tax credit, and is available to you if you meet IRS income guidelines. Here’s how it works:
- Let’s suppose you owe $2,000.00 in taxes. At the same time, you’re eligible for $3,500.00 in EITC. You’ll end up owing no tax at all once the credit is applied, and you’ll also receive the difference of $1500.00 as a refund.
On the other hand, a nonrefundable tax credit will only reduce your overall tax liability. A good example is the Child Tax Credit. If you qualify you can deduct a maximum of $2000.00 from your tax bill, but you will not receive a refund.
A tax deduction works differently in that it will reduce the taxable income you’ll need to report. Typical deductions include student loan interest, self-employment tax, child support, and moving expenses. Most people without kids will use the standard deduction, which is adjusted each year.
Tax deductions are subtracted from your gross income, which in turn lowers the income figure you’ll need to report on your tax forms. Here’s some math to demonstrate how it works:
- Your total income: $30,000.00
- The standard deduction: $6300.00 (if you’re single; see this chart for other filing statuses.)
- Total taxable income: $23,700.00 ($30,000.00-$6300.00=$23,700.00)
You’ll only have to pay tax based on income of $23,300.00 instead of the original amount of $30,000.00 as seen in this example. Your outcome may vary depending on whether you choose to itemize your deductions, or take the standard deduction. You can’t do both, unfortunately.
Tax credits and tax deductions each have a different effect on your taxes. By understanding the differences between them, you’ll be better equipped to prepare your tax and understand your tax liability for a given year.