Tax credits vs. tax deductions: Which is better for your wallet?
Credits and deductions are two important ways for filers to reduce their tax bill
After a three-month delay, tax time for Americans is finally here.
This year, as a result of the coronavirus pandemic, the IRS extended Tax Day from April 15 to July 15, giving Americans three months longer than typical to file their taxes on income earned in 2019.
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For last-minute filers who want to reduce the bite of their tax liability, there are two important ways to do so: tax credits and tax deductions. While both deductions and credits can save you a significant chunk of money on your taxes, they work in very different ways.
Here's what you need to know, and how to determine whether credits or deductions are better for your wallet.
Tax credits:
Tax credits are subtracted from the taxes that you owe -- not your taxable income -- and give you a dollar-for-dollar reduction on your liability. For instance, if your federal tax bill was $10,000, and you're entitled to a $2,000 tax credit, your bill would be cut to $8,000.
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There are three types of tax credits: a non-refundable tax credit, which can reduce your bill to zero, but won't provide you with a refund; a refundable tax credit, which means you get a refund, even if it's more than what you owe; and a partially refundable credit, when a percentage of the credit is refundable.
Some popular examples of tax credits are:
- Earned Income Tax Credit: It provides support to low- and moderate-income working parents. Workers receive a credit equal to a certain percentage of their earnings (it varies by family size). In 2019, the maximum credit for families with one child is $3,526, while the maximum credit for families with three or more children is $6,557.
- Child tax credit: It provides a credit of up to $2,000 per child under the age of 17. If the credit exceeds taxes owed, families may receive up to $1,400 per child as a refund. The credit is reduced by 5 percent for single parents earning more than $200,000, and married couples earning more than $400,000.
A list of the different types of tax credits can be found here.
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Experts largely agree that tax credits are better for reducing your bill than deductions. Most likely, if you ever had to choose between a $100 deduction and a $100 credit, you'd pick the credit, which would reduce your bill by $100, according to TurboTax. On the other hand, how much money you saved by reducing your taxable income by $100 would depend on your tax bracket. If you were in the 24 percent tax bracket in 2019, a $100 deduction reduces your taxes by $24.
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“Credits win every time because they are a dollar-for-dollar reduction of your tax bill,” Megan Brinsfield, CPA and director of financial planning at Motley Fool Wealth Management, said. “Deductions will reduce your overall income before applying to your tax rate.”
Tax deductions:
A tax deduction, meanwhile, lowers a person's tax liability by reducing their taxable income, which thus lowers the amount of tax that you owe. For instance, one common type of deduction on your federal income tax return is the standard deduction. If your income was $50,000, your standard deduction would reduce your taxable income by $12,200 for 2019. That means your taxable income would be just $37,800.
Itemized deductions are numerous and their amounts vary from person to person.
Some receipts that are commonly itemized, according to TurboTax:
- State income taxes
- Mortgage interest
- Property taxes
- Charitable contributions
- Certain medical and dental expenses above 7.5 percent of your adjusted gross income
- State sales and local tax