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Tax credits and deductions both decrease what you'll pay in taxes, but in different ways. Tax deductions lower your taxable income and potentially reduce what you'll pay in taxes as a result, while tax credits reduce your tax bill dollar for dollar and may even increase your refund.
What Is a Tax Credit?
Tax credits directly reduce the amount of taxes you owe, providing you with a dollar-for-dollar reduction. For example, if you qualify for a $3,000 tax credit, you'll save $3,000 on your tax bill.
In some cases, a tax credit can not only lower your tax bill but can result in a tax refund. For example, if you qualify for a fully refundable tax credit of $1,000 and you owe only $700 in taxes, you'd receive a tax refund for the $300 credit in excess of your tax bill.
Not all tax credits are refundable, however. A nonrefundable tax credit can reduce your tax bill down to $0, but if the credit is worth more than you owe on your tax bill, a nonrefundable credit won't result in a check from the IRS for the difference.
Common Tax Credits
Here are some popular tax credits you may use to lower your tax bill or increase your refund:
- American opportunity tax credit: The American opportunity tax credit is a partially refundable credit that helps cover expenses for the first four years of higher education. Eligible students, or taxpayers who claim the student as a dependent, can claim a maximum annual credit of $2,500. If the credit reduces a tax bill to zero, 40% of any remaining credit (up to $1,000) can be received as a tax refund.
- Child tax credit: The child tax credit is a fully refundable tax credit for families with qualifying children. Eligible families can claim the credit whether or not they have income and with or without a permanent address. The child tax credit is available for families whose income is less than $200,000 for single filers or less than $400,000 for those filing jointly. Families must earn at least $2,500 to qualify.
- Child and dependent care credit: The child and dependent care credit can help cover qualifying care costs for an eligible child or other dependent, calculated based on your income and a percentage of the care costs. The credit is considered refundable only for the 2021 tax year.
- Earned income tax credit: The earned income tax credit is a refundable tax credit that can help qualifying low- to moderate-income earners reduce their tax bill. The credit's value varies based on whether or not you have children or other dependents and if you are disabled. Eligibility for the earned income tax credit also varies depending on your filing status and family size.
- Saver's credit: Qualifying taxpayers can receive a nonrefundable tax credit for certain contributions to employer-sponsored retirement plans or individual retirement accounts. If you qualify, your Saver's credit can range from 10% to 50% of your contributions, depending on the contributions you make and your income.
What Is a Tax Deduction?
A tax deduction lowers your taxable income and, in turn, lowers your tax bill. Unlike a tax credit, a deduction won't lower your tax bill dollar for dollar. Instead, the amount a deduction reduces your tax liability depends on your income tax bracket.
Your income tax bracket determines the tax rate you pay on various chunks of your income. Since the marginal tax system increases tax rates as income rises, deductions can result in a higher dollar amount savings for those with higher incomes.
Here's how the tax brackets break down for single filers and married couples filing jointly:
|Marginal Income Tax Brackets for the 2022 Tax Year|
|Tax Rate||Income Tax Brackets for Single Filers||Income Tax Brackets for Married Couples Filing Jointly|
|10%||$0 - $10,275||$0 - $20,550|
|12%||$10,276 - $41,775||$20,551 - $83,550|
|22%||$41,776 - $89,075||$83,551 - $178,150|
|24%||$89,076 - $170,050||$178,151 - $340,100|
|32%||$170,051 - $215,950||$340,101 - $431,900|
|35%||$215,951 - $539,900||$431,901 - $647,850|
|37%||$539,901 or more||$647,851 or more|
Tax deductions can impact your tax savings like this: If you're a single tax filer and the highest tax rate that applies to your income is 35%, a tax deduction of $2,000 could save you $700. If your highest income tax bracket is 22%, however, the same tax deduction could save you $440.
All tax filers are granted the option of accepting a standard deduction that lowers their taxable income by a certain amount of money or itemizing their tax deductions and subtracting specific, tax-deductible expenses from their tax base.
For single filers, the standard deduction is $12,950 in the 2022 tax year and $25,900 for joint filers. There's no limit on the itemized deduction amount, although there are dollar amount caps for certain types of expenses.
Typically, high-income taxpayers tend to benefit from itemizing, whereas many taxpayers will benefit more from the standard deduction. To determine whether you should take the standard deduction or itemize deductions, you'll need to compare your allowable itemized deductions to your standard deduction amount. Then, pick whichever reduces your taxable income the most.
Common Tax Deductions to Lower your Taxable Income
Here are some popular tax deductions that may help you lower your taxable income:
- Educator expenses deduction: Eligible teachers can deduct up to $250 in qualified expenses for purchases like school supplies, materials, equipment, books and professional development courses. Teachers can claim this deduction whether or not they itemize or claim the standard deduction.
- Home office deduction: If you use your home office exclusively for qualified business purposes, the home office deduction can help you write off a portion of the rent and property taxes you pay based on the allowable square footage of the office.
- Medical and dental expense deduction: Some taxpayers may be able to deduct medical and dental care expenses for themselves and for their spouse and dependents. The deduction is dependent on income and covers certain qualified medical expenses.
- State and local tax deduction: The state and local tax deduction may allow qualified taxpayers to deduct certain state and local taxes they paid in the current tax year, up to $10,000.
Not every tax deduction requires you to itemize your deductions in order to claim it.
Does a Tax Credit or a Tax Deduction Lower Your Bill More?
If all else is equal, a tax credit will lower your tax bill more than a tax deduction of the same amount. That's because a tax credit reduces your taxes dollar for dollar, whereas a tax deduction lowers the amount of income you pay taxes on.
To understand the difference, consider a $1,000 tax credit versus a $1,000 tax deduction.
Calculating the money a tax credit saves you is straightforward: If you qualify for a tax credit of $1,000, your tax bill will be reduced by $1,000.
Calculating the money a deduction saves you requires a bit more math. If you qualify for a tax deduction of $1,000, your taxable income will be reduced by $1,000. The reduction will affect the taxable income in your highest tax bracket. For example, if the highest tax bracket that applies to your income is 15%, this deduction will result in a tax savings of $150 (15% of $1,000).
Even at the highest tax bracket, 37%, a $1,000 deduction would put $370 back in your pocket—much less than a $1,000 credit.
Understand Tax Credits and Deductions to Maximize Savings
Tax credits and tax deductions are two ways to reduce your tax bill. Understanding how credits and deductions work and how they differ can help you save more money.
Remember that taking the standard deduction can help you reduce your taxable income by a specific dollar amount to lower your tax bill, even if you don't qualify for other specific deductions. Alternatively, some taxpayers can save more by itemizing.
If you need help filing your taxes, reaching out to an accountant can help you navigate taxes and maximize your deductions and tax credits. There are also a number of free tax preparation options for taxpayers with various incomes.