Making Sense of Tax Credits and Deductions

Tax season can be confusing with all the rules around deductions, credits, income, and filings. What do they all mean for your bottom line? While tax deductions and tax credits both impact your tax liability, they do so in very different ways.  Understanding the difference can help you take advantage of both.

What are Tax Deductions?

A deduction reduces your taxable income. In other words, it lowers the amount of your earnings that will actually get taxed. Donations to charity, mortgage interest, 401(k) contributions, and medical expenses above a certain level are common deductions. If you make $60,000 and have $5,000 in deductions, you only pay income tax on $55,000.

What are Tax Credits?

Credits directly chop dollars off your final tax bill, rather than just reducing taxable income. Two people with identical incomes could owe very different amounts depending on applicable credits. Some examples are child tax credits, education credits and green energy home improvement credits. If you owe $5,000 in taxes, a $500 credit would make your new bill $4,500.

Here’s how it might look in the real world…

Client #1 has taxable income of $45,000 and owes around $4,900 in federal tax pre-deductions/credits. She makes a $1,000 401(k) contribution and qualifies for a $1,500 child tax credit.

• 401(k) contribution is a deduction, lowering taxable income to $44,000 
• $1,500 child credit directly cuts taxes owed from $4,900 to $3,400

Client #2 earns $70,000 per year and owes about $9,100 in federal taxes before any deductions or credits. He paid $8,000 in mortgage interest and gave $500 to charity.  

• Mortgage interest is a deduction, lowering his taxable income to $62,000
• Charitable gift also a deduction making taxable income $61,500

Each client’s individual tax burden was impacted by the  amount of deduction or credit applied. 

Common Tax Credits

• Child Tax Credit - This can reduce taxes owed by up to $2,000 per qualifying child under age 17.

• Earned Income Tax Credit (EITC) - This benefits low-to-moderate income households, especially those with children. The amount varies based on income, marital status, and number of kids.

• Child and Dependent Care Credit - You can claim up to 35% of childcare expenses incurred so you can work. The percentage goes down as income goes up.

• American Opportunity and Lifetime Learning Credits - Tax credits for paying college tuition and fees for yourself or dependents. Together these can be worth over $2,500.

• Premium Tax Credit - Helps pay a portion of health insurance premiums purchased through federal or state exchanges. Amount depends on your income and family size.

Common Tax Deductions

• Mortgage Interest Deduction - For the interest portion paid on a home loan for your primary residence. Up to certain limits.

• State and Local Tax Deduction (SALT) - Can deduct amounts paid the previous year for state income and property taxes, up to $10,000 total per year. 

• Charitable Donation Deduction - For itemized returns, this includes gifts to qualified 501(c)(3) nonprofit groups.

• Traditional 401(k) and IRA Contributions - Money put into these retirement accounts reduces taxable income for the year.

• Medical and Dental Expenses - If total out-of-pocket healthcare expenses exceed 7.5% of adjusted gross income, the overage can be deductible.

Netting It Down

Tax deductions and credits work differently, but both effectively lower your tax liability. Deductions reduce your taxable income. Meanwhile, tax credits provide dollar-for-dollar reductions to your actual final tax bill, bringing down overall taxes owed. 

Every deduction and credit claimed puts more money back in your pocket! Proper tax planning is crucial to cut your tax burden to the lowest amount legally possible.
Wondering whether you are taking advantage of every possible deduction and credit that you can? Reach out to us today, and schedule a meeting!