The Federal Tax Code is a complicated document. Research shows that more than half of the Americans feel frustrated when they try to understand it. But the truth is, the federal tax code is there for your own benefit.
Deductibles such as tax deductions and tax credits can lower your tax amount allowing you to hold on to more of your earnings. However, to take advantage of it, having a clear concept of how these tools work is essential.
In this article, I’ll talk about the differences between tax deductions and tax credits to help you save as much on your taxes as possible.
Understanding Tax Deductions
Tax deductions are expenses that you can subtract from your gross income, which, in turn, lowers your taxable income. Think of it this way – tax deductions give you discounts on the income that you’re being taxed on.
Your tax bracket determines the total value of your tax deduction. Here’s a quick example: if you’re in the 22% tax bracket and you claim a $1000 deduction, you’ll be saving $220 bucks on your taxes, which is 22% of the $1000 deduction.
The higher your deductions, the lower your taxable income, and consequently, the less you’ll owe in taxes.
Common Tax Deductions Include:
- Mortgage interest: Homeowners can deduct the interest paid on their mortgage up to certain limits.
- Charitable contributions: Donations made to qualified organizations can be deducted from your taxable income.
- Medical expenses: If your medical expenses exceed a certain percentage of your adjusted gross income, you may be eligible for a deduction.
- State and local taxes: You can deduct certain state and local taxes, such as property taxes and income taxes (or sales taxes, if applicable).
Understanding Tax Credits
Unlike deductions, which reduce your taxable income, tax credits directly reduce the amount of tax dollars you owe. Credits are typically more valuable than deductions because they provide a dollar-for-dollar reduction in your tax liability.
Basically, a $1000 tax credit will reduce your tax bill by $1000. Your tax bracket has no effect on tax credits. The value of tax credit is the same for everyone on all tax brackets.
Common Tax Credits Include:
- Earned Income Tax Credit (EITC): The EITC or EIC is designed to provide a financial boost for low- to moderate-income working individuals and families.
- Child Tax Credit: Parents or guardians may be eligible for this credit, which can offset a portion of the costs associated with raising children.
- Education credits: Credits like the American Opportunity Tax Credit and the Lifetime Learning Credit are designed to offset the costs of higher education.
- Energy-efficient home improvements: Certain energy-saving home upgrades, such as solar panel installations or energy-efficient windows, may qualify for tax credits.
Tax Deductions vs. Tax Credits: Key Differences
Here are the key differences between tax deductions and tax credits:
- Effect on Tax Liability:
The biggest difference between tax deductions and tax credits is how they impact your taxes. Tax reductions reduce your taxable income. Tax credits on the other hand directly reduce the amount of tax you owe.
- Value:
Since tax credits offer a dollar-for-dollar tax reduction, they are often considered more valuable. Tax deductions depends on the tax bracket of the person, but tax credit is same for everyone.
- Phase-Outs:
Tax credits are usually subject to income limitations. That means, as your income goes up, certain credits can start to decrease or disappear entirely.
- Type of Expenses Covered:
Tax deductions can cover a wide variety of expenses ranging from mortgage interests to medical costs or even business expenses. Tax credits on the other hand are usually a bit more targeted rewarding things like educational pursuits or energy-efficiency improvements.
- Refundability:
Finally, certain tax credits are refundable, meaning you can get a refund if the credit value exceeds your tax amount. Tax deductions are non-refundable.
Get in Touch
Navigating the intricacies of the federal tax code isn’t everyone’s cup of tea; I get it. But with my help and financial expertise backing you up, you don’t need to worry about biting off more than you can chew.
Get in touch with me today, and let me help you sort out your tax benefits.
Disclosure: Please note, changes in tax laws or regulations may occur at any time and could substantially impact your situation. While familiar with the tax provisions of the issues presented herein, Raymond James Financial Advisors are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.
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