When it comes tax time, most of us really only care about one thing: paying as little as possible without breaking any laws, of course.
And while there are legal ways to lower your overall tax burden, not all of these tactics are created equal — which becomes readily apparent as you’re looking over that mountain of IRS paperwork.
In some cases, you may be eligible for a tax deduction, whereas in others, you might qualify for a tax credit.
Don’t get us wrong; both are good. But what’s the difference between a tax credit vs. tax deduction, and why does it matter?
What Is a Tax Deduction?
Let’s start with the tax-lowering method that’s probably more familiar to you: tax deductions. These work by lowering the total amount of your income that’s subject to income tax.
For example, you can often deduct your contributions to a traditional IRA. So if you make $50,000 in a year, but put $5,000 of it into your traditional IRA, only $45,000 of your income will be taxed — even though you technically made $50,000 total.
Thus, tax deductions save you money by exposing less of your income to taxes. In this case, that last $5,000 would have fallen into the 22% income tax bracket for 2019, which means the deduction saves you $1,100, i.e., 22% of $5,000.
Other common deductions include mortgage interest, charitable donations, property taxes and medical expenses that are more than 10% of your AGI, or adjusted gross income.
What Is a Tax Credit?
Now that we’ve got tax deductions squared away, what about tax credits?
Like tax deductions, tax credits lower your overall tax burden. But rather than reducing how much of your earnings are subject to income tax, tax credits directly reduce your tax bill dollar for dollar.
In short, they’re more powerful than tax deductions… which means they’re also harder to come by and constrained by stricter rules.
That said, there are a few tax credits you might qualify for, such as the American Opportunity Tax Credit and Lifetime Learning Credit for education-related expenses, or the Saver’s Credit, which rewards you for contributing to a qualified retirement account. There are also tax credits for people over 65, those with disabilities and those who care for children or other dependents.
But remember how we said they were scarcer and harder to qualify for? Well, all of the credits we mentioned are subject to fairly stringent income tax limits, which means they’re not available to those who earn more above a certain AGI.
Meanwhile, most taxpayers can claim the standard deduction, which in 2020 is $12,400 for single filers and $24,800 for married couples filing jointly.
Still, it’s worth determining which tax credits you’re eligible for, if any, next time Tax Day comes around. Fortunately, the IRS has gotten hip enough to create a slate of interactive web tools that’ll help you figure out exactly what you’ve got coming to you — so you can keep more of your hard-earned money in your pocket.
Jamie Cattanach’s work has been featured at Fodor’s, Yahoo, SELF, The Huffington Post, The Motley Fool and other outlets. Learn more at www.jamiecattanach.com.