Tax credits and deductions are two significant ways individuals can minimize their tax liability before Tax Day. However, while the two are often compared and conflated, they are fundamentally different – and understanding that difference can help you make better decisions as a taxpayer and avoid missing out on crucial savings. Ultimately, tax credits and deductions don’t need to be pitted against each other.
It never is and never was a dichotomous choice. Under most circumstances, you get both – but you might not get them all. Tax credits are generally designed to lessen the tax burden on lower-income Americans. At the same time, deductions apply to every taxpayer. Still, they are either fixed (standard) or variable (itemized), with variable deductions potentially much more significant, albeit more difficult to qualify for.
Understanding Tax Credits
Tax credits are either refundable or non-refundable checks the IRS writes to add to your tax account. If your taxable income nets you a tax liability of $1,250, and you get a tax credit of $250, your tax liability is effectively lowered to $1,000. If your tax credit was refundable, and you’ve already paid your $1,250 through estimated payments or withheld wages, then the IRS will send you a tax refund of $250. But not all tax credits are refundable.
Non-refundable tax credits can still come in handy, helping you avoid additional tax liability if you made a mistake on your return or did not account for an increase in income when determining your withholding. Non-refundable tax credits are ultimately less helpful, especially to low-income taxpayers, who are less likely to be able to make full use of the credit if their taxable income is low to begin with. Refundable tax credits, on the other hand, can often mean money in your pocket.
However, tax credits require qualification. You may qualify for multiple different tax credits, but be sure to have the paperwork handy to prove it. The IRS can and will request information to ensure that your account is qualified to receive a tax credit. A few tax credits you may qualify for include:
- Earned Income Tax Credit: The Earned Income Tax Credit is a refundable tax credit available to low-income taxpayers. It is essentially an anti-poverty tax credit meant to help ease the burden of Social Security taxes (as part of general payroll taxes) and inflation. Credit amounts vary and are locked off for taxpayers above a certain income threshold, depending on the number of dependents and filing status.
- Insurance Premium Tax Credit: The premium tax credit helps qualifying individuals and families ease the burden of hefty healthcare insurance premiums, as long as the qualifying requirements are met and the individual files Form 8962. It is also a refundable tax credit.
- Child and Dependent Care Tax Credit: Previously non-refundable, the child tax credit became partially and then fully refundable as part of the relief package for the coronavirus pandemic. As the name implies, child tax credits are only available to low-income taxpayers with minor dependents.
- Mortgage Interest Tax Credit: The mortgage interest credit is a non-refundable tax credit available to individuals with qualifying income levels paying a mortgage on their new home through Form 8396.
- American Opportunity Tax Credit: The American opportunity tax credit is refundable up to 40 percent of its total $2,500 tax deduction and is available to payers of post-secondary education students. In other words, this is a tax credit for those who financed a qualifying student.
Tax Credits and Stimulus Checks
Another example of a temporarily available tax credit is the stimulus check sent to every qualifying American taxpayer as part of the 2020 Coronavirus Aid, Relief, and Economic Security Act (CARES Act) and the 2021 American Rescue Plan. These non-taxable refundable tax rebates were distributed through the IRS for taxpayers to use as an economic infusion at the height of the pandemic crisis. The main difference between most tax credits and the stimulus check tax rebate is that there is no clawback function.
For example, even if you’re behind on estimated tax payments, the IRS can’t send you a stimulus check and reclaim part of it to pay for your outstanding taxes. The IRS also can’t count the stimulus check towards your taxable income for 2020 and 2021. The pandemic stimulus checks were not rolled out equally. Some taxpayers received them before others, and there were complications with claiming these tax credits. Some people even fell victims to scams.
Understanding Tax Deductions
Tax deductions are different from tax credits. Where a tax credit is applied to your tax liability, and either refundable (i.e., you receive the remainder as cash) or not, tax deductions are applied to your total taxable income on every tax return you send to the IRS. While tax credits are not guaranteed to every taxpayer and have specific qualifying requirements, every taxpayer is entitled to a tax deduction and may choose between a standard deduction and a series of itemized deductions. Choosing one foregoes the other.
Standard vs. Itemized Tax Deductions
Most taxpayers use standard deductions, especially in the aftermath of the 2017 Tax Cuts and Jobs Act, which massively expanded the standard deduction while cutting a few itemized deductions. The standard deduction was raised from $6,500 per individual to $12,000 per individual in 2018. In 2022, the standard deduction (adjusted for inflation) is:
- $12,950 for single or married taxpayers filing separately
- $25,900 for married couples filing jointly
- $19,400 for head-of-household filers
Itemized deductions are variable, changing the total amount pulled off your taxes based on the individual deductions you qualify for, from unreimbursed medical expenses and theft losses to charitable contributions. However, itemized deductions may also draw additional scrutiny from the IRS, so be sure to have the paperwork to back up your itemization.
Tax Mistakes and the IRS
Whether it’s the wrong type of deduction, a missed tax credit, or a simple math error, we all make mistakes on our taxes. You can help avoid them by hiring professionals. Professional tax preparation services take the guesswork out of Tax Day and help you minimize your tax liability. Speak to a tax professional about filing an amended tax return today, or learn more about tax preparation services and tax relief for the next Tax Day.