Tax deductions vs. tax credits: How to tell the difference
Tax credits and tax deductions may be the most satisfying part of preparing your tax return.
Both reduce your tax bill, but in very different ways.
Tax credits directly reduce the amount of tax you owe, giving you a聽dollar-for-dollar reduction of your tax liability. A tax credit valued at $1,000, for instance, lowers your tax bill by the corresponding $1,000.
Tax deductions, on the other hand, reduce how much of your income is subject to taxes.聽Deductions lower your taxable income by the聽percentage of your highest聽. So聽if you fall into the 25% tax bracket, a $1,000 deduction saves you $250.
The catch to聽tax credits
Some tax credits are intended to help聽cover individual costs around buying a first home, adopting a child, child care expenses, home office expenses or聽caring for an elderly parent.
But these are nonrefundable tax credits. 聽If you don鈥檛 owe a lot in taxes to begin with, you don鈥檛 get the full value if the credits take your tax bill below zero. 聽In other words, a $600 tax bill combined with a $1,000 credit doesn鈥檛 get you a $400 tax refund check.
Other credits are refundable. If you qualify to take refundable tax credits 鈥� things like the Earned Income Tax Credit, the Health Coverage Tax Credit, the Making Work Pay Credit, the Child Tax Credit and the Additional Child Tax Credit 鈥� the value of the credit goes beyond your tax liability and can result in a refund check.
The IRS lays out specific criteria you must meet to qualify for聽both nonrefundable and refundable credits.
As you run the tax credit calculations in your return, keep in mind that you must establish the amount of your gross income tax liability before you apply any credits. The credits don鈥檛 reduce your taxable income.
But tax deductions do.
The catch to聽tax deductions
There are two types of tax deductions.
The standard deduction is a one-size-fits-all reduction in the amount of your income that鈥檚 subject to tax.聽You don鈥檛 have to do anything to qualify for the standard deduction or provide any documentation.
You can claim the standard deduction on whichever form you file:.聽The standard deduction in 2015 for single filers and married couples filing separately is $6,300; it鈥檚 $12,600 for married couples filing jointly. For those filing as heads of household, the standard deduction is $9,250.
But you may be better off opting to use聽the second type of deduction, the itemized deduction, instead.
Itemizing allows you to total the amount you spent on allowable deductions such as home mortgage interest, medical expenses or charitable donations. If together they exceed the value of the standard deduction, you鈥檒l want to itemize. 聽You鈥檒l need to use the regular 1040 filing form and Schedule A.聽
Taking the standard deduction or itemized deductions is an either/or situation. 聽You can claim one kind or the other, but not both. 聽
And, just as with tax credits, taking certain deductions requires meeting certain qualifications based on your filing status, current life events and the amount of your income that鈥檚 taxable. Be sure you meet IRS criteria to qualify聽for聽both tax credits and deductions.
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