Tax Credit vs Deduction: What’s the Difference?

When tax season rolls around, your first thought is how much money you can save with tax credit or deductions. Every dollar you put toward your future counts!

According to a Pew Research study, nearly half of Americans today are frustrated with the tax system’s complexity. Whether you’re confused on how to deduct or what tax breaks you qualify for, tax season is infamous for being highly stressful. You’ll be happy to know that you likely qualify for tax credit or a few deductions.

What’s the difference between tax credit vs deduction? We’ll whittle down this complexity into a direct result you can look forward to.

Breaking Down Today’s Tax Breaks

It’s challenging to keep up with the tax system at the best of times. New rules are introduced on a rolling basis, with some of them unique to your state or your industry.

Moving Expenses are No Longer Tax Deductible

This change is a relatively new entry in the tax space, thanks to the Tax Cuts And Jobs Act introduced in 2017. If you’re thinking of writing off your moving receipt or gas expenses, reconsider.

The only exception to this rule is if you’re part of the military and the move is sponsored through your employer. 

Charitable Donations 

Charitable donations are another new entry you should be aware of. While it’s often tricky for philanthropic donations to exceed the allotted amount on a tax return, the pandemic has changed things.

If you’re a single filer, you now have the ability to claim a tax break on any and all donations up to $300. If you’re married? Double that to $600.

Related: Easily Calculate The R&D Credit For Great Returns

Defining the Tax Credit

You might have sat down with a tax professional in the past and learned about tax credit. It’s a pleasant surprise that reduces how much you owe…but how?

Tax credit is straightforward: it reduces the amount you owe by a direct dollar amount. For example, if you receive $500 in tax credit, you’ll have a reduced liability by $500. Does that mean tax credits are entirely flawless?

Far from it. Many tax credits are non-refundable, which means you’ll receive a smaller refund check if you select them on your form. Whether or not this decision is worth it will be up to you.

Refundable Tax Credits

Refundable tax credits are where you can actually bring your tax liability below zero, and the IRS will owe you money. There are a few refundable tax credit categories you might fall under, which you should always double-check with each new tax season.

The first refundable tax credits you can apply for is the Earned Income Tax Credit (EITC). This relatively simple filing is designed to reduce the tax liability of those that don’t make much in the first place. This tax credit is a prime choice for self-employed individuals, families with children, and students on a tight budget.

Child Tax Credit

As touched on above, families with children are under more pressure than average when it comes to managing money. The child tax credit provides relief to struggling families based on the number and age of children in the household.

The dollar range is a recent change to the child tax credit you need to know. While dependents could originally be claimed $2,000 each, this number has since grown to $3,600. 

Defining Deductions

This section is a little more complex than tax credit. Deductions have two flavors: the standard deduction and the itemized deduction.

What is theStandard Deduction?

This deduction is basic and easy to use. You don’t have to actually provide any documentation or receipts: you’ll simply receive a deduction based on how much taxable income you have.

Whether you’re self-employed or have a traditional full-time job, you can qualify for the standard deduction.

For tax year 2021 (what you file in early 2022) the standard deduction is $12,550 for single filers, $25,100 for joint filers and $18,800 for heads of household.

What is an Itemized Deduction?

This area is a little more complex and provides you with more options for saving money.  If you aren’t used to keeping track of your deductions, consider changing your accounting habits now.

Itemized deductions are expenses that are directly tied into your yearly income. They’ll change a little depending on your job, your filing, and your industry. What some taxpayers can write off as a deduction doesn’t automatically apply to your unique situation.

Keep in mind you have to choose between a standard deduction or an itemized deduction. While choosing both sounds quite nice, it’s not allowed. However, you can take advantage of both tax credit and deductions.

Does a Tax Credit Mean a Refund?

This aspect can’t be stressed enough. You can receive a refund with tax credit, but it depends on the amount of money you owe.

If you receive a tax refundable credit that is higher than what you owe, you will receive a refund. For example: if you owe just $500 in taxes, but qualify for a $1,000 credit, you will receive a $500 refund.

Choosing between tax credits and deductions can be tricky. We provide years of experience in one convenient place to help you reach the right decision.

What are Deductible Expenses I Can Use?

Now it’s time to start whittling down ways you can save money. This part is the least stressful because you likely have a few deductions just waiting to be used!

Home Mortgage Interest

Let’s start off with the most commonly used itemized deductions. Take a few minutes to look over your year and see which areas you may qualify for.

Home mortgage interest is one place you can start itemizing deductions. You are allowed to deduct on the first $750,000, though you can split that number in half if you are married. 

Medical Expenses 

The second most common deductible expense is the medical expense. Nearly 20% of Americans today struggle to pay for their medical care, making this a very useful deductible. These medical deductions must be considered unreimbursed, so keep a close eye on your paper trail.

Areas you can consider deducting include (but aren’t limited to):

  • Preventative care
  • Dental care
  • Surgeries
  • Mental health care (such as telehealth sessions with a psychologist)
  • Vision

Remember you can’t exceed 7.5% of your gross monthly income with your total medical expenses. Keep a paper trail on all of your bills, fees, and purchases so you’re not missing out.

Charitable Donations

Unfortunately, not everything you donate qualifies as a charitable donation. With the holidays right around the corner, the season of giving still comes with a few caveats.

While crowdfunding platforms like Kickstarter and GoFundMe are popular, they don’t qualify under current tax rules. The only exception to this rule is if a 501 organization creates the Kickstarter you’re supporting. 

Which charitable donations can you write off on your tax return? Your first step is to make sure you’re donating to a qualified organization. This means they have to be a registered non-profit. Fortunately, these organizations frequently provide physical or digital tax receipts that you can take with you.

Good examples of tax-deductible charitable organizations include (but are not limited to):

  • Goodwill
  • World Central Kitchen
  • Make-A-Wish

Keep in mind you can’t deduct indefinitely. You can deduct around 60% of your AGI, though this number can be more limited depending on the organization. 

Are There Deductions for Self-Employed Individuals?

If you’re self-employed, you’re likely wondering how you can run a business more sustainably. With 2022 around the corner, now is a great time to start figuring out your most common deductions.

Some of the deductions you can consider will revolve around your home office, studio, or monthly expenses. As long as these deductions are directly related to running your business, you can write them off on your tax return. 

Write-offs for self-employed individuals can look like:

  • Subscription fees for services like Adobe or Grammarly
  • Online portfolio domain names, add-ons, and subscriptions
  • Business insurance
  • Renter’s insurance (if you work from home)
  • Certain utilities
  • Computer equipment
  • Art supplies

If you’re not sure what part of your business is tax-deductible, it’s best to get a professional opinion. You don’t want to accidentally claim the wrong deductible and send the IRS inaccurate business numbers.

Are There Deductions for Families with Children?

Families with children have a tall order to address. Everything from food to school supplies has to be carefully budgeted.

There are several tax deductions for families with children. We touched on earned income tax credit above, which provides a fixed amount for each dependent under your care. This credit also applies to adoption expenses. If you adopted a child within your tax year, you could use the adoption credit.

Families sometimes overlook education tax credits. This deduction is a fantastic way to take the sting out of purchasing school supplies, tuition, and books for your children. If your child is aiming for a Bachelor’s degree, you can claim this deduction for the full four years they’ll be attending.

Speaking of which…

Are There Deductions for College Students?

Last but not least, we have deductions for college students. The most common deduction you’ll hear about is the American Opportunity Tax Credit.

This useful resource allows you to claim 100% of the first $2,000 spent on university or college. The following $2,000 will be bumped down to a 25% claim. Anything beyond that cannot be claimed on the credit.

Another reason this tax credit is so appealing is its simplicity. If you’re attending four years of college, you automatically qualify. You also qualify if you have a yearly average income of $80,000. This straightforward deduction should pay off fees, books, and everyday expenses such as bus fare.

Another deduction for college students is the Lifetime Learning Credit. While you can’t use this alongside the American Opportunity Tax Credit, it has its own unique benefits. Choose this deduction if you’re aiming for a certificate course or a two-year technical degree.

Related: Qualified Research Expenses (QRE): A Complete Guide

What Other Tax Credits or Deductions Should I Know About?

There are plenty of opportunities for you to save money in a given tax year. Even if you’ve used up all the ones you qualify for, new opportunities will be introduced in the future.

The Work Opportunity Tax Credit (or WOTC) is one you should consider if you’re employed. You can also try the Employee Retention Credit, which has provided significant relief in the chaos of the pandemic.

Related: Business Startup Costs & Tax Deductions 2021 [Guide]

Conclusion

The difference between tax credit and deduction is essential for being a responsible taxpayer. You’re not just looking out for the best interests of your country: you’re looking out for your future.

A tax credit reduces the amount of tax liability you owe. While this can take the heat off your tax return, it also results in a smaller tax refund. It’s up to you which option is most preferable.

Deductions come in two varieties: the standard deduction and the itemized deduction. The former is based on your yearly income and is relatively straightforward. The latter is more complex and depends on your business expenses.

Has the pandemic upended your business or studies? Contact us today for a free quote so you can start filing smarter, quicker, and more accurately.

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