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What is a Tax Deduction vs Tax Credit?

What is a Tax Deduction vs Tax Credit?

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 and 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 the Earned income credit (EIC), "Make Work Pay" credit, Lifetime learning credit, Saver's tax credit and 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 credit (EIC) and the adoption expense credit. The EIC, 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.

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. Some familiar non-refundable tax credits are Child credit, Foreign tax credit and 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.

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?