Tax credits are generally more beneficial because they apply directly to the taxes owed and lower your tax bill. Tax deductions on the other hand reduce taxable income, which indirectly lowers the tax bill by an amount that depends upon your tax bracket. Most tax credits start phasing out at a certain income level and may even be unavailable for very high-income earners.
Comparison chart
| Tax Credit | Tax Deduction | |
|---|---|---|
| Impact on tax bill | Directly lowers tax bill (the amount of tax owed) by an amount equal to the tax credit. | Indirectly lowers the tax bill by lowering the taxable income. Reduction in tax bill is equal to a fraction of the deduction amount. The fraction depends upon the marginal tax rate of the filer. |
| Examples | Child and Dependent Care tax credit, Earned Income Credit, “Make Work Pay” credit, lifetime learning credit, green energy tax credits. | Mortgage interest for primary residence, property taxes, state income taxes, business use of home, charitable donations. |
| What is it? | A dollar-for-dollar reduction in the actual tax owed | A reduction in taxable income |
| Calculation | A tax credit is subtracted from the tax owed AFTER calculating tax liability. | A tax deduction is subtracted from income BEFORE calculating tax liability. |
| Refundable? | Some tax credits are refundable, which means that they can reduce tax owed to below zero, which results in a refund. | A tax deduction is never refundable. Deductions can only reduce taxable income towards zero but you can't make it negative or claim a refund based on deductions. |
| Eligibility | Tax credits are usually based on specific expenses or circumstances, such as having children, paying for education, or installing energy-efficient home improvements. | The standard deduction is available to everyone. Itemized deductions are based on expenses like mortgage interest, charitable donations, or medical expenses. |
What are tax deductions?
Tax deductions reduce your taxable income and are of two types: standard deduction and itemized deduction. You can choose to take either the standard deduction ($14,600 for single; $29,200 for married couples for the 2024 tax year) or, if your tax-deductible expenses for the year are larger, you can choose to itemize them on your return. In general, the discussion around tax credits and deductions deals with itemized deductions.
Examples of Tax Deductions
Some examples of the best tax deductions that you can itemize include state income taxes, property taxes, mortgage interest, charitable donations and the business use of your home.
What are tax credits?
Tax credits are a direct reduction of the amount of tax due. They are applied after tax is calculated.
Tax credits for 2024
For the 2024 tax year, several major tax credits are available to help reduce your tax liability. Here are some of the most significant ones:
- Earned Income Tax Credit (EITC)
- Eligibility: Primarily for low-income working individuals and families.
- Amount: Up to $7,830 for three or more children, $6,960 for two children, $4,213 for one child, and $632 for no children.
- Income Limit: Generally, AGI must be $66,819 or less, and investment income must not exceed $11,600.
- Premium Tax Credit
- Purpose: Helps offset health insurance premiums for low-to-middle-income taxpayers.
- Eligibility: Available for those purchasing health insurance through the Marketplace.
- Claiming: Can be taken in advance or claimed at tax filing.
- American Opportunity Tax Credit
- Purpose: Supports education expenses for the first four years of post-secondary education.
- Amount: Up to $2,500 per student.
- Eligibility: Student must be enrolled at least half-time, and income limits apply (MAGI of $80,000 or less for singles, $160,000 or less for joint filers).
- Lifetime Learning Credit
- Purpose: Supports education expenses beyond the first four years.
- Amount: Up to $2,000 per tax return.
- Eligibility: Available for undergraduate, graduate, or non-degree courses; no enrollment requirement.
- Saver's Credit
- Purpose: Encourages retirement savings.
- Amount: 10% to 50% of up to $2,000 in retirement contributions ($4,000 for joint filers).
- Eligibility: Income limits apply (e.g., $38,250 for singles, $76,500 for joint filers).
- Child and Dependent Care Credit
- Purpose: Supports childcare costs.
- Amount: 20% to 35% of up to $3,000 for one child or $6,000 for two or more children.
- Eligibility: Available for working individuals or couples with qualifying childcare expenses.
How they work
To understand how tax deductions and tax credits work and what impact they have, consider this scenario: Jack and Jill are a married couple and their total income for the year is $100,000. So they fall in the 25% income tax bracket.
$8,000 worth of tax deductions lower their tax bill by $2,000. On the other hand, $3,000 worth of tax credits lower their tax bill by a further $3,000. Every dollar of a tax credit lowers the tax bill by $1 but every dollar of a tax deduction lowers your tax bill by 10-35 cents, depending upon your marginal tax rate.
Refundable vs Non-refundable Tax Credits
Tax credits come in two forms: refundable and non-refundable. Refundable tax credits provide benefit even if you do not owe the IRS any tax. In other words, if you owe $300 in tax for one year and receive $400 in tax credit, the IRS will pay you $100 instead.
Non-refundable tax credits cannot exceed the amount of tax you owe. While they can reduce the owed taxed down to $0, the government will never owe you money due to non-refundable tax credits.
Qualifying for the tax credit
There are usually income limits that apply to tax credits. Eligible credits start phasing out above a certain income level and sometimes vanish entirely for high income tax filers. Sometimes a tax deduction is available as an alternative to a tax credit and taxpayers can choose one or the other. For example, dependent care expenses like daycare or babysitters. The child and dependent care tax credit allows working parents to claim a tax credit for a portion of the expenses incurred on daycare for their kids while they work. The amount is capped at $3,000 per child and also depends upon the annual income of the parent(s). For high income earners, an alternative to using this tax credit is setting up an FSA account with up to $5,000 that can be spent on daycare tax-free. This is a tax deduction which reduces taxable income by $5,000 and helps avoid federal and state income taxes, social security and Medicare taxes.
References
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