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What is a Tax Credit vs Tax Deduction?

What is a Tax Credit vs Tax Deduction?

It's a good thing most of us only have to file taxes once a year. With all of the confusing terms, complex language, and mind-numbing math, it's as if the people who write the tax code just wanted to bore us and trick us into a mistake or two.

Even the helpful parts - like when you'd get money back - are tough to deal with. You can easily mix up two key terms: tax deductions and tax credits. Both serve the same purpose, which is to reduce your tax burden based on certain categories of income or expenses, but they work in different ways.

Below is a description of each, and an outline of how deductions and credits are different.

Tax Deductions

In its simplest form, an income tax deduction is a reduction in taxable income. Tax deductions are probably familiar to you because they cut your taxes in broad categories like:

- Medical expenses

- State and local income taxes

- Property taxes

- Mortgage interest

- Charitable contributions

Most people love tax deductions because they usually involve expenses you have to take on anyway, like your mortgage and property taxes. The tax benefit seems like a great way to recover money you had to spend, but in the end, not everyone gets to take advantage of these deductions. You have to itemize your return - and not everyone can do that.

The standard tax deduction - what the IRS gives you even if you don't itemize - is $5,700 if you're filing as single and $11,400 for a married couple filing jointly. Unless your deductions exceed that amount, you won't be able to itemize. Usually, people who don't have a mortgage can't itemize, and thus can't take advantage of all of the available deductions. That's where tax credits come in.

Tax Credits

While tax deductions work by lowering taxable income, tax credits are a direct reduction of the tax due. After you figure out your taxable income and subtract your deductions, you calculate your tax due. You still have a chance to reduce that amount, often significantly, by taking advantage of any allowable tax credits.

The major tax credits usually get plenty of press, and a little controversy too, so you've probably heard of some of the big ones, like:

- Earned Income Tax Credit (EITC)

- Making Work Pay Tax Credit

- Lifetime Learning Credit

- Saver's Tax Credit

- Green Energy Tax Credits

The list goes on, and your tax adviser can help you sift through to find which ones are relevant to you. Despite the wealth of options, tax credits are relatively simple, and the good news is that you can take them whether you itemize or not. But they're still part of the tax code, so there are confusing rules and exceptions to all of them. The main distinction for tax credits is whether they are refundable or non-refundable.

Refundable Tax Credits

Refundable tax credits are the ones that are easiest to embrace, because they have fewer restrictions and limitations. You can benefit from a refundable tax credit even if you have no tax liability and no withholding. There are several credits in this category, including the Earned Income Tax Credit (EITC) and the adoption expense credit. The EITC, which is available to low income filers, can provide you with a refund of several thousand dollars.

Another common refundable credit that you may able to take is the Making Work Pay tax credit. This credit can save you as much as $400, or $800 if you're married filing jointly and both you and your spouse have earned income.

For example, assume the following:

- Your filing status is single

- You earned $15,000 from your job in 2010

- Your tax liability, before figuring allowable credits, is $300

- Your tax owed, therefore, is $300

Before you figure out credits, you're looking at $300 you'll owe to the IRS in April. But, when you figure in $400 from the Making Work Pay tax credit, now they owe you $100! A refundable tax credit is almost like finding money.

Non-Refundable Tax Credits & Exceptions

Non-refundable tax credits can also make a big difference. In fact, they can reduce your tax liability all the way down to nothing. But they have a major limitation: The amount of your credits can't exceed the amount of tax you owe. In short, you're not going to be able to use them to get a refund.

If you think about that example of the Making Work Pay tax credit above, if the situation were exactly the same except that the credit were non-refundable, you'd only be able to get the $300 to bring your tax liability to $0. You wouldn't owe anything, but you wouldn't get a $100 refund like you did in the above example.

Some familiar non-refundable tax credits are:

- Child credit

- Foreign tax credit

- Child and dependent care tax credit

Exceptions Can Help

While exceptions often mean bad news, in the case of the child credit, the exception can actually boost your refund. Though the child credit - $1,000 per dependent child under the age of 17 - is non-refundable, you can usually shift the non-refundable portion of the credit over to the additional child credit, which is refundable.

In this example, imagine:

- Your filing status is married filing jointly, with two dependent children under 17

- You earned $40,000 in 2010, all from your jobs

- Your tax liability, before figuring allowable credits, is $1,500

- Your two children allow for a child credit of $2,000 ($1,000 each)

- But the child credit is limited to your tax liability because it's non-refundable, in this case $1,500

- Normally, you'd have to forfeit the remaining $500 and would not receive a $500 refund

But the exception to the rule allows you to slide the forfeited $500 over to the additional child credit, which means you just have to do some math to get yourself a big refund. The additional child credit lets you claim the lesser of two amounts: the amount you might have to forfeit (in this case $500) or 15% of your earned income in excess of $3,000.

That's where the tax code gets complicated again, so take a look at the calculation: 15% of your earned income in excess of $3,000 is $5,550 ($40,000 - $3,000 = $37,000; $37,000 * 15% = $5,550). Since $500 is the lesser of the two amounts, that's the one you're allowed to take. Thus, instead of forfeiting the credit, you now have an extra $500 refund.

Note: The examples above are general, and may not apply in your specific situation. Always check with your tax adviser or IRS guidelines to be sure that you qualify for any deduction or credit, as there are usually income parameters or other limits that may reduce or even eliminate your eligibility.

Final Word

Despite the limitations of some types of deductions and credits, you're not facing an either/or situation. You can take advantage of all types, and that's good news. Of course, as you can see from the calculations, finding your way to tax relief can be complicated. Good online tax preparation software can make the job much smoother, especially when allowances and carry-forwards kick in.

Even if you use tax software, however, you need to know what the deductions and credits are, when they apply, and when you may not be able to take them. What tax deductions and tax credits have been the most beneficial, or the most troublesome, for you?