We are running a series of posts for tax procrastinators. We started with some tips and are finishing up with a post later in the week about taxes and charitable donations. Today's post tackles the difference between a Deduction and a Credit, which is a useful distinction to understand. Spoiler alert on #3, a Modern Giving account goes a long way in making tax time super easy...but we are getting ahead of ourselves.
There are two primary ways to pay less taxes on your income! First, you can claim deductions, which effectively decreases the amount of income that you are required to pay taxes on (less income = less taxes owed!). Second, you can receive tax credits there are credits that you can receive, which decrease the actual amount of taxes owed. (More credits = less taxes!). If you use tax software or work with a tax professional, they will know how to handle these, but its still useful to know the difference and how they impact the cash in your pocket, or bank account, or giving account.
The invaluable NerdWallet, helps explains this:
Tax credits directly reduce the amount of tax you owe, giving you a dollar-for-dollar reduction of your tax liability.
Tax deductions, on the other hand, reduce how much of your income is subject to taxes.
There a whole bunch of different tax credits available, all designed to get people to take some action or to change their behavior in some way. Some examples include: the first-time home buyer credit, credits for purchasing solar panels and/or energy-efficient windows, a federal adoption credit for families that adopt a child, and credits related to covering child and dependent care, among many others.
They do further complicate things by making some credits nonrefundable and others refundable. The difference determines if you can actually receive money back beyond what you owe in taxes (refundable) or not (nonrefundable). For example, if you owe $500 and you have $1,000 of nonrefundable credits, you will just not have to pay any taxes, but you will NOT receive a $500 refund. LAME. If those were refundable credits, then you could receive a $500 refund.
Charitable donations, real estate taxes and home mortgage interest, interest paid on student loans, and in some cases medical expenses are all examples of deductions. They can be added together and subtracted from your total income so that you owe taxes on a lower total amount of income.
The government actually gives everyone a 'standard' deduction each year. In 2017, that standard deduction for single filers is $6,350. So everyone gets that deductions subtracted from their income off of the top. However, if you add up all of your individual deductions and it is bigger than the standard deduction, then you can use that bigger deduction and save more. That is often called itemizing your deductions. Woo hoo for when that happens, aka Adulting.
Comparing Tax Credit and Tax Deductions
TurboTax (they know a thing or two about these taxes), does a nice job comparing the two:
Tax credits generally save you more in taxes than deductions. Deductions only reduce the amount of your income that is subject to tax, whereas, credits directly reduce your tax bill. To illustrate, suppose your taxable income is $50,000 and you have $10,000 in deductions, which reduces your taxable income to $40,000. If that $10,000 would have been taxed at a rate of 25 percent, then the deduction saves you $2,500 in tax. If the $10,000 was a tax credit instead of a deduction, your tax savings is $10,000 rather than $2,500.
So there you have it. Tax Credits vs. Tax Deductions 101. Now you can at least nod along when Uncle Larry the accountant brings it up.
Pinkaloo Technologies LLC does not provide tax or legal advice. Each of us have unique circumstances and we suggest that you work with a qualified tax advisor for your specific situation.