As we begin the final sprint to the end of the fiscal year, it’s important to have a clear understanding of the various strategies that can lower your tax bill. Two of the most common and often misunderstood tools at your disposal are tax deductions and tax credits. Both offer savings, but they work in very different ways. For businesses and individuals alike, understanding the difference between these two concepts is essential to optimizing your tax return and ensuring you don’t leave money on the table.
What is a Tax Deduction?
A tax deduction reduces the amount of your income that is subject to taxes. By lowering your taxable income, deductions decrease the amount of income on which you pay taxes. Deductions don’t directly lower your tax bill, but they can help you pay a lower tax rate by reducing the income bracket you fall into.
For example, if your taxable income is $80,000 and you claim $10,000 in deductions, your taxable income drops to $70,000. You are taxed on this lower amount, which means you pay less in taxes overall. Deductions are often tied to expenses or circumstances, such as charitable donations, mortgage interest, and business-related expenses.
Here are some common tax deductions for individuals and businesses:
- Mortgage Interest: Homeowners can deduct the interest paid on their mortgage, which can add up to significant savings.
- Charitable Contributions: Donations to qualifying charitable organizations can be deducted, potentially reducing taxable income.
- Student Loan Interest: Interest on student loans is also deductible up to a certain limit.
- Business Expenses: For businesses, operating expenses like rent, supplies, and advertising costs are deductible.
What is a Tax Credit?
A tax credit, on the other hand, directly reduces the amount of taxes you owe. Instead of reducing your taxable income, a tax credit is subtracted from your total tax bill, dollar for dollar. Because of this, tax credits can often be more valuable than deductions.
There are two main types of tax credits: non-refundable and refundable.
- Non-refundable tax credits can only reduce your tax bill to zero. If the credit is larger than the taxes you owe, the excess will not be refunded to you.
- Refundable tax credits, however, allow you to receive the full credit even if it exceeds the taxes you owe. This can result in a refund, which can be particularly beneficial for lower-income taxpayers.
Some common tax credits include:
- Earned Income Tax Credit (EITC): Designed to benefit low- to moderate-income workers, this credit is refundable, meaning if your credit exceeds your tax liability, you receive the difference as a refund.
- Child Tax Credit: Available to families with qualifying children, this credit can be partially refundable.
- Energy-Efficient Home Improvements: Homeowners who make energy-saving upgrades may qualify for a tax credit for a portion of the costs.
- Research and Development Credit: Businesses that invest in innovation and product development can qualify for this valuable tax credit.
Tax Deductions vs. Tax Credits: How Much Can You Save?
While both deductions and credits reduce the amount you pay in taxes, tax credits are generally more valuable than deductions. Why? Because while deductions reduce the amount of income taxed, credits reduce the tax itself. Let’s look at an example to illustrate the difference.
Suppose you are a single filer with $80,000 in taxable income, and you’re in the 22% tax bracket. Let’s say you have a $2,000 tax deduction and a $2,000 tax credit.
With a $2,000 deduction: A $2,000 deduction would lower your taxable income to $78,000. At a 22% tax rate, that saves you $440 (22% of $2,000).
With a $2,000 tax credit: The same $2,000 as a tax credit would reduce your tax bill directly by $2,000.
As you can see, the tax credit results in more savings because it directly reduces your taxes owed, while the deduction only reduces the amount of income that gets taxed.
How to Maximize Tax Deductions and Credits
To make the most of both deductions and credits, you must understand which ones you qualify for and how to apply them properly. Here are a few tips for individuals and business owners:
- Keep Detailed Records: Ensure you have receipts and proper documentation for all deductible expenses and qualifying credits. In the event of an audit, these records will be crucial.
- Review Itemized vs. Standard Deductions: Many taxpayers choose the standard deduction, which is a set amount that reduces your taxable income. However, if your itemized deductions (mortgage interest, charitable contributions, medical expenses) exceed the standard deduction, itemizing can offer more savings.
- Consult a Professional: The tax code is complex and frequently changes. Working with our firm can help you identify deductions and credits you might otherwise overlook. This is especially true for business owners, who often have more opportunities for deductions and credits but also face more complex tax rules.
Upcoming Tax Law Changes
Tax law is always evolving, and it’s important to stay aware of new legislation that may affect your deductions or credits. For example, the Child Tax Credit expanded significantly during the pandemic but has since normalized. However, Presidential candidate Kamala Harris proposes returning the CTC to pandemic levels. Similarly, renewable energy credits and deductions for business expenses can fluctuate based on new policies and regulations, many of which may change as a result of this year’s election.
Familiarize, Optimize
Understanding the difference between tax deductions and tax credits is essential to managing your tax liability effectively. While deductions lower your taxable income, credits directly reduce your tax bill. Both can lead to significant savings, but tax credits typically have a more powerful impact on your bottom line. Whether you’re an individual filer or a business owner, staying informed and working with a professional can help you maximize your tax benefits and save money come tax time. Call us, and let’s talk about tax planning.