For US taxpayers, tax deductions and tax credits present significant tax-saving opportunities. The key difference is that while tax deductions reduce an individual’s taxable income, tax credits reduce their liability dollar for dollar, making them the more advantageous option in terms of tax-saving potential.
With hundreds of different tax deductions and credits available to US taxpayers, some of the most common include:
1. 401(k) Contributions Deduction
2. Adoption Credit
3. Charitable Donations Deduction
4. Gambling Loss Deduction
5. Home Office Deduction
6. IRA Contributions Deduction
7. Lifetime Learning Credit
8. Medical Expenses Deduction
9. Mortgage Interest Deduction
10. Self-employed Expenses Deduction
Individuals must meet specific IRS criteria to qualify for both tax deductions and credits.
Tax Deductions
Tax deductions lower a person or organization’s taxable income, effectively reducing the amount of income tax they are liable to pay. Deductions are expenses incurred by the taxpayer that are reduced from their gross income before their tax liability is calculated for a particular tax year.
Different regions of the United States have different tax codes, enabling taxpayers who have incurred certain expenses to deduct them from their taxable income. These codes are set annually by tax authorities at the state and federal level, with codes that work in one region not applying in others. Federal tax codes are often implemented to encourage taxpayers to contribute to programs for the betterment of society.
There are two main types of tax deductions: standard and itemized.
Standard deductions are generally the least complicated route. They stipulate a pre-determined amount, avoiding the need for complicated tax calculations. Standard deductions are a one-size-fits-all reduction in annual taxable income. Taxpayers do not need to produce documentation or do anything to qualify for a standard reduction. For the 2021 tax year, the standard deduction for a single person is $12,550, $18,800 for head of household, and $25,100 for a married couple filing jointly.
If a taxpayer decides on itemized deductions, then these deductions apply to any amount exceeding the standard deduction limit. Where married couples filing jointly have incurred significant expenses throughout the tax year, such as medical expenses, mortgage interest and property taxes, retirement savings contributions, or charitable donations, opting for itemized deductions could help them achieve significant tax savings, although certain limitations apply. For example, itemized healthcare deductions are only deductible where the total of all healthcare costs incurred exceeds a stipulated percentage of adjusted gross income.
The taxpayer chooses whether they wish to make standard or itemized deductions, selecting one or the other. They cannot use both.
Tax Credits
Instead of reducing taxable income, tax credits are subtracted dollar for dollar from the amount of taxes a person or organization owes to the government. They are therefore the more favorable option in terms of reducing tax bills. Various types of tax credit are allocated to individuals or businesses according to industry, classification, or specific location.
Governments typically implement tax credit schemes to serve as an incentive, stimulating the population to follow particular behaviors. One example could be encouraging individuals to save for old age or to replace energy-inefficient appliances with environmentally friendly alternatives. Certain tax credits, such as the low-income housing tax credit or earned income tax credit, are issued to help disadvantaged demographics.
There are three different types of tax credit: refundable, nonrefundable, and partially refundable.
Since they are paid out in full, refundable tax credits are the most advantageous type in terms of tax-saving potential. Taxpayers can apply the full amount of the credit, irrespective of their tax liability or income. If, after the deduction of refundable tax credits the taxpayer’s tax liability falls below $0, they are entitled to a refund.
Deducted directly from an individual or organization’s tax liability, nonrefundable tax credits can only be claimed in the same accounting year. Once the tax return is filed, any unclaimed nonrefundable tax credits lapse. They cannot be carried over from one tax year to the next.
If the amount of nonrefundable tax credits reduces the taxpayer’s tax liability below $0, they are not entitled to a refund, hence the term nonrefundable. Certain other tax credit types, such as child tax credits, are only partially refundable.
Conclusion
Both tax deductions and tax credits can significantly reduce tax bills, but tax credits are more advantageous. For example, with a $1,000 tax deduction, a taxpayer who falls into the 22 percent tax bracket saves $220, whereas with a $1,000 tax credit, the same taxpayer saves the full $1,000.
Rather than merely reducing taxable income, tax credits reduce the taxpayer’s tax bill dollar for dollar. In the case of refundable credits, taxpayers can achieve a tax refund if their tax liability falls below $0, or, in the case of partially refundable credits like American opportunity tax credits, a proportion of the deficit, depending on the particular tax credit in question.
