When you file your taxes, you’ll want to take advantage of all the tax credits and deductions available to you. This can help reduce your tax bill significantly. However, it is important to understand the difference between credits and deductions. One difference is that credits provide a dollar-for-dollar reduction in your taxes, while deductions provide an indirect tax reduction by lowering your taxable income, thereby lowering your total tax bill. There are a wide variety of credits and deductions available, but which ones you qualify for will depend on your situation.
Tax credits directly reduce the amount you owe — a $500 credit means you pay $500 less in taxes. Credits are generally offered to help offset certain expenses, including the purchase of a first home, childcare costs, adopting a child, caring for elderly parents or energy efficiency projects, such as as the installation of solar panels. Business owners can also benefit from tax credits. Tax credits are less common than tax deductions. They are worth varying amounts, and whether or not you qualify will depend on factors such as filing status, age, employment, and education. There are two main types of tax credits, which work differently: refundable and non-refundable.
Refundable tax credits are the most versatile credits you will encounter
They are subtracted in full from the amount of tax you owe after deductions and can be used to increase your refund. These credits offer the unique opportunity to reduce your tax payable to less than zero. Let’s say you owe $500 in taxes and are entitled to a refundable credit of $800. Your tax payable will be reduced to minus $300 and the IRS will refund you $300. Some of the most common refundable credits include the additional child tax credit, the earned income tax credit, and the medical coverage tax credit.
Non-refundable tax credits reduce the amount of your income tax up to the amount of income tax you owe
A non-refundable credit cannot reduce your tax payable below zero. Non-refundable credits expire the year you claim them and cannot be carried over to the next year. Common examples include the adoption tax credit, child tax credit, foreign tax credit, and mortgage interest tax credit.
Understanding tax deductions
Tax deductions indirectly reduce your income tax bill by lowering your taxable income. The amount you receive in tax deductions depends on your marginal tax rate, also called your tax bracket. For example, if you are in the 24% bracket, a $1,000 deduction will reduce your taxes by $240, or 24% of $1,000. There are two types of deductions: standard deductions and itemized deductions. As a taxpayer, it is best to use the higher amount.
Most people take the standard deduction. The amount you can claim is based on your filing status, and this amount is adjusted for inflation each year. See table below for 2022 figures.
You can choose to itemize if the total of all your deductions is greater than the standard deduction. You can only deduct expenses determined by the IRS, which include certain medical expenses, certain state and local taxes, mortgage interest, capital expenditures, charitable contributions, and certain employment-related amenities; all require documentation.
The impact of deductions and credit
Various tax credits and deductions can affect your tax bill in different ways. The table below illustrates the impact of deductions and credits of the same value for four different taxpayers. The taxpayer with a 0% tax rate has no taxable income, so he can only benefit from a refundable tax credit if he has earned income. (Their taxable income could have been reduced to zero by tax deductions.) Because they pay no taxes, non-refundable credits and tax deductions cannot reduce their tax bill.
A taxpayer in the 10% tax bracket could take advantage of the full refundable credit, but only part of the non-refundable credit; this credit cannot reduce their income tax below zero. The maximum income tax someone in the 10% bracket will pay is $995, so the $1,000 non-refundable credit can only reduce taxes by that amount. The deduction for someone in the 10% bracket is $100, or 10% of $1,000. Filers in the 24% and 35% brackets can take full advantage of both credits for a deduction of $240 and $350, respectively. Before taking tax credits or deductions, check the IRS rules to make sure you qualify.