I am sure you have heard of a tax credit and a tax deduction, but do you know what the difference between them is? Both deductions and credits can save you a lot of money on your taxes, they work in very different ways.
What is a Tax Deduction?
A tax deduction is a result of a tax-deductible expense or exemption that reduces your taxable income for a given year. A common deduction on your federal income tax return is the standard deduction. The standard deduction consists of the sum of the basic standard deduction and any additional standard deduction amounts for age and/or blindness. You can’t take the standard deduction if you itemize your deductions. How does this work? Say your income was $50,000 – your standard deduction (if single or married filing separately) would reduce your taxable income by the 2021 standard deduction of $12,550, so your taxable income would now be $37,450.
What is a Tax Credit?
Tax credits are subtracted from the taxes you owe, not your taxable income. An example of a common credit is the Child Tax Credit. Beginning with tax year 2021, the Child Tax Credit was expanded. If you have a qualifying child, you can take a credit of up to $3,600 for each child under 6 and $3,000 for each child aged 6-17, depending on your income.
So, which is better: Tax Deduction or Tax Credit?
To put it simply, if you were ever faced with a hypothetical choice between a $100 deduction and a $100 credit, you would most likely prefer to receive the tax credit. A tax credit reduces your tax dollar-for-dollar, in this case $10, while a deduction reduces your taxable income by that $100. The resulting amount of tax you save will depend on your tax bracket. For instance, if you are in the 24% tax bracket for tax year 2021, a $100 deduction will reduce your taxes by $24, a $100 credit would reduce your taxes by $100.
Don’t worry about trying to figure out which credits or deductions you should take, or if you should itemize or take the standard deduction. Our expert accountants at Intentional Accounting will evaluate your personal situation and help you take the deductions and credits you are eligible for.
