Many look at the new year as a fresh start. It can be a way to put the previous year behind you and focus on the future. But the new year also means that tax time is approaching.
Workers in the United States will receive their W-2 forms from their employers, while contractors will collect 1099 forms from clients to prepare for the April 15 tax deadline.
There’s no doubt that taxes can be a confusing topic. The tax code isn’t exactly light reading. One of the most commonly confused parts of tax law — and a piece that affects all taxpayers — is the difference between tax deductions and tax credits. Both can help to reduce your tax burden, but in very different ways.
Read More: Overlooked Tax Deductions & Credits
Throughout the year, tax management is important. Just within the scope of investing, it can increase your portfolio’s return by 1% per year. While that may not sound like very much, it can lead to a nearly 40% difference in the value of your portfolio over 35 years. That translates to retiring earlier, traveling, helping your kids pay for college, or meeting the financial goals that matter to you. Read up on 5 Tax Hacks for Investors with our free guide.
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What is a Tax Deduction?
A tax deduction reduces your taxable income. When you file your income tax return, you can claim any deduction that you’re eligible for. Then, when it’s actually time to calculate how much you owe, your tax rate is applied to a smaller portion of your income. As a result, you pay less in taxes.
When you file your taxes, the IRS gives you two options: You can either claim the standard deduction ($12,400 per person for the 2020 tax year) or you can itemize your deductions. It might make sense to itemize deductions if the total amount of deductions you’re eligible for adds up to more than $12,400.
Let’s look at a quick example. Imagine someone makes $50,000 per year. When they file their tax return, they claim the standard deduction. Now instead of paying taxes on the full $50,000, they only pay taxes on $37,600.
Common tax deductions or someone using itemized deductions include:
- Charitable contributions
- Mortgage interest
- Medical and dental expenses
- Property taxes
- Moving expenses
There are some deductions that you can claim even if you claim the standard deduction. Those deductions include deductions for student loan interest and contributions to health savings and retirement accounts. These are known as above-the-line deductions.
What Is a Tax Credit?
While a tax deduction reduces the amount of your income you must pay taxes on, a tax credit reduces the actual amount of taxes you owe. When you file your taxes, you calculate your tax credits at the very end.
Common tax credits include:
- The Earned Income Tax Credit
- The Child Tax Credit
- The Adoption Tax Credit
- Affordable Care Act Premium Tax Credit
- American Opportunity Tax Credit
Tax credits can either be refundable or non-refundable. A refundable tax credit reduces the amount of taxes you owe, and if the credit is more than your tax bill, you get a refund. A non-refundable credit reduces your tax bill, but you don’t get the difference in the form of a refund if the credit is more than you owe.
Let’s look at an example of a taxpayer who claims the Child Tax Credit. Throughout the year, this taxpayer has money withdrawn from their paychecks to pay income taxes. When tax season rolls around, they calculate what they owe by taking their income, subtracting the standard deduction, and subtracting the amount they’ve already paid in taxes.
Let’s say for this example that the taxpayer finds they owe $500 in income taxes. But because they have a child, they can claim the Child Tax Credit, which allows parents to reduce their tax bill by $2,000 per child. The Child Tax Credit is a refundable credit. So instead of owing $500, the taxpayer in our example now gets a refund of $1,500.
The Difference Between Tax Deductions and Tax Credits
Deductions and credits both reduce the amount you owe in taxes for the year, but they do it in different ways. Tax deductions reduce your taxable income, while tax credits directly reduce your tax liability. Put another way, tax deductions come into play before you calculate your tax liability, while tax credits come into play after.
Here’s a table that shows how each tool can reduce your tax bill.
|$5,000 Tax Deduction||$5,000 Tax Credit|
|Adjusted gross income||$50,000||$50,000|
|Minus tax deduction||($5,000)|
|Effective tax rate*||12%||12%|
|Minus tax credit||($5,000)|
|Final tax bill||$5,400||$1,000|
*The United States has marginal tax brackets, meaning you pay a different tax rate on different parts of your income, depending on which tax bracket it falls into. Someone’s effective tax rate is the average rate you end up paying.
How to Claim Tax Deductions and Tax Credits
You’ll claim your tax deductions and tax credits when you fill out your Form 1040 (aka your tax return). Here’s how you fill out the form:
- Add up your total income.
- Decide whether you’ll be claiming the standard deduction or itemizing deductions. If you itemize your deductions, you’ll have to complete a Schedule A form.
- Subtract all of your deductions from your total income to find your taxable income.
- Multiply your taxable income by your tax rate.
- Subtract your tax credits.
The tax software on the market makes this process easier. They ask you for certain information and then plug it into a Form 1040 on your behalf. If you hire an accountant to do your taxes, they’ll do this part for you.
Read More: The Pros & Cons of Hiring a Tax Professional
The Bottom Line
Both tax deductions and tax credits can help you to reduce the amount of taxes you owe in an entirely legal way. It’s best to take advantage of as many deductions and credits as you can. If you aren’t sure which ones you might be eligible for, you can use tax software or consult an accountant.
And remember, managing your tax burden can be a year-round endeavor. You can keep tabs on your finances and investments using Personal Capital’s free, online tools. Millions of people use these financial tools to see all of their accounts in one place, analyze investments and uncover hidden fees, and explore ways to make their money work harder for them.
Personal Capital compensates Erin Gobler for providing the content contained in this blog post.