Tax credits and tax deductions may be the most satisfying part of preparing your tax return. Both reduce your tax bill, but in very different ways.
- Tax credits directly reduce the amount of tax you owe, giving you a dollar-for-dollar reduction of your tax liability. A tax credit valued at $1,000, for instance, lowers your tax bill by the corresponding $1,000.
- Tax deductions, on the other hand, reduce how much of your income is subject to taxes. Deductions lower your taxable income by the percentage of your highest federal income tax bracket. So if you fall into the 22% tax bracket, a $1,000 deduction saves you $220.
|* Example rate only. The United States uses a progressive tax system.|
|A $10,000 tax deduction…||…or a $10,000 tax credit?|
|Less: tax deduction||($10,000)|
|Less: tax credit||($10,000)|
|Your tax bill||$22,500||$15,000|
The catch to tax credits
- Some are nonrefundable. That means that if you don’t owe a lot in taxes to begin with, you don’t get the full value if the credits take your tax bill below zero. In other words, a $600 tax bill combined with a $1,000 nonrefundable credit doesn’t get you a $400 tax refund check.
- Some credits are refundable. If you qualify to take refundable tax credits — things such as the Earned Income Tax Credit or the Child Tax Credit — the value of the credit goes beyond your tax liability and can result in a refund check.
- The IRS lays out specific criteria you must meet to qualify for both nonrefundable and refundable credits.
A big decision about tax deductions
There are two types of tax-deduction strategies: taking the standard deduction or itemizing.
Itemizing allows you to total the amount you spent on allowable deductions. … If together they exceed the value of the standard deduction, you’ll want to itemize.
The standard deduction
- The standard deduction is a one-size-fits-all reduction in the amount of your income that’s subject to tax. You don’t have to do anything to qualify for the standard deduction or provide any documentation.
- You can claim the standard deduction on Form 1040. The amount varies depending on your filing status.
|Filing status||2019 tax year||2020 tax year|
|Married, filing |
|Head of |
- Itemizing allows you to take advantage of deductions such as home mortgage interest, medical expenses or charitable donations. If together your itemized deductions exceed the value of the standard deduction, you’ll want to itemize so you pay less tax. You’ll need to use the regular Form 1040 and Schedule A.
- Taking the standard deduction or itemized deductions is an either/or situation. You can do one or the other, but not both.
- Just as with tax credits, taking certain deductions requires meeting certain qualifications based on your filing status, current life events and the amount of your income that’s taxable. Be sure you meet IRS criteria to qualify for both tax credits and deductions.