Do You Know the Key Differences Between a Tax Credit and a Tax Deduction? | Insights from Our Financial Advisors

We know that our clients like you love the idea of ‘tax credits’ and ‘tax deductions’. But when it comes down to understanding them, are you able to identify their fundamental differences? Let’s break each of them down:

Here is What a Tax Credit Really is...

To explain simply, a tax credit is a reduction on the amount of actual tax owed. Tax credits do not impact your taxable income or your tax bracket. The easiest way to think of them is as reductions that come after the fact; for example, after you’ve already determined how much you owe to the government. There are several types of tax credits that exist and which are determined by your income, your dependents, whether you have a student attending college, and more. Here are common credits: 

• Residential Energy Tax Credit
• Earned Income Tax Credit
• Child and Dependent Care Credit
• Child Tax Credit
• Lifetime Learning Credit
• Adoption Credit

Usually, tax credits are going to be either refundable or non-refundable. Depending on what your tax credit is, this will affect how much you will receive back on your tax refund.

What is a Refundable Tax Credit? 

A Refundable Tax Credit is a tax credit that can be paid back to you if it is unused. As an example, if you owed $500 in taxes, but your eligible tax credit is $1,200, you will receive the remaining $700. 

What is a Non-Refundable Tax Credit? 

A non-refundable tax credit cannot be refunded and will only cover the taxes you owe. If your credit is in excess of what you owe, you will not receive this amount as part of your tax refund. As an example, if you owe $500 in taxes and your tax credit is worth up to $1,200, the $500 will be covered but you will not receive the additional $700. 

What Are Tax Deductions?

A tax deduction is used to reduce the amount of your taxed income. By decreasing this amount, you can qualify for a lesser tax bracket meaning you are subject to a lower tax percentage. Tax deductions can be separated into two categories: itemized deductions and above-the-line deductions.

Itemized Deductions 

An itemized deduction will allow you to limit your taxable income. Here are a few types of itemized deductions: 

• Charitable donations
• Medical expenses
• Property taxes
• Mortgage interest

Anyone has the option to add your deduction separately on taxes, also known as “itemizing”, but most will choose the standard deduction determined by the IRS. For the 2022 tax year, here are the deduction amounts:  

• Single or married but filing separately: $12,950
• Married and filing jointly or qualifying widow(er): $25,900
• Head of household: $19,4001

In most cases, itemized deductions will not exceed standard deductions, making it a more common choice.

Above the Line Deductions

Above-the-line deductions will be used to help you reduce your AGI, or ‘adjusted gross income’, which can qualify you for some itemized deductions and tax credits. Your ‘AGI’ can be found by subtracting ‘above-the-line’ deductions from your gross tax income. This lower AGI can assist you in claiming significant tax credits or deductions that may depend on your income level. Here are a few, common ‘above-the-line’ deductions:  

• Deductible IRA contributions
• Alimony paid
• Educator expenses
• Student loan interest
• Moving expenses of armed forces members

When fully utilized, both tax credits and tax deductions can work in a taxpayers favor, especially when used together. Becoming familiar with the difference between them will provide you with a strong starting point for beginning your research and identifying which credits and deductions your family may be eligible for in the coming tax year.