With tax season upon us, I thought it was as good a time as ever for a short post about the differences between tax deductions and tax credits! Now, always make sure to research yourself, or even better, to hire a professional to help with your taxes (I will do a later post about the advantages to this). But basically, the difference is this: with a tax deduction, you deduct the amount of taxable income you have. A tax credit actually allows you to subtract from the taxes themselves.
Okay, so to get into an example (all the numbers are completely arbitrary and don’t represent the actual taxes you may have): so, imagine you were planning to use a federal tax deduction of $1000. Now, if your total taxable income is $50,000, with that deduction, it now drops down to a total taxable income of $49,000. If you have a 22% tax rate (the US federal tax rate for income between $41,776 and $89,075 (1)), this $1000 deduction will save you $220. However, if this $1000 is actually a tax credit, this will then subtract directly from your overall tax bill! So using the same taxable income of $50,000 again, you will originally be paying a tax bill of roughly $6308 (I will get into how to calculate out your taxes using the progressive income brackets, but the federal tax form 1040 will show you the exact amount you pay in their tables in the instructions as well). So in this case, a tax credit will save you $1000 instead of only $220 for a tax deduction!
Now, you may ask, what if I have more tax credits than I have taxes to pay? In some cases, such as the earned income tax credit, you get any amount of the credit back that is not used to cover your taxes. However, per the IRS, other credits, such as those for electric vehicle purchases, are nonrefundable and you will not get any money back if you have more tax credits than you have taxes to pay. Additionally, there are some partially refundable credits as well.
So how do you find these tax credits and deductions? Sometimes they are more obvious, such as the electric vehicle tax credits, which seemed to have been in the news endlessly as politicians debated how much credit to give, to what manufacturers, etc. However, many will require more research on your end. Additionally, if you think you may be able to get several deductions and credits, it may be a good idea to hire a tax advisor to help you, as they could help you earn back far more money than they cost, as well as making sure you get as much money as possible while staying legal. But this is entirely dependent on the individual, so you need to know your own tax situation!
Lastly, always remember to do your own research, and to do your taxes correctly! A small mistake or incorrect deduction could lead to a larger fine if the IRS audits you (which is rare, but you never know).