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Tax Credits vs. Tax Deductions

It's possible you could benefit from tax deductions and credits when you prepare your tax return. The IRS calculates these types of tax breaks differently, and the impact on your return can vary.

Keep reading to find out everything you need to know about how these tax breaks work.

How Are Tax Credits and Tax Deductions Different?

A tax credit reduces your tax liability dollar for dollar. A tax deduction reduces your taxable income.

“A deduction is worth only as much as the tax bracket you’re in, while a credit saves taxes dollar for dollar,” Barbara Weltman, author of "J.K. Lasser’s 1001 Deductions & Tax Breaks 2023," says.

“For example, if a taxpayer is in the 22% bracket, a $1,000 deduction saves $220 in taxes while a $1,000 credit saves $1,000 in taxes. Deductions are more valuable the higher the tax bracket a person is in," she says.

Deductions may also affect your income: You can subtract some of them before you calculate your adjusted gross income. These are known as above the line deductions.

Mark Luscombe, principal federal tax analyst with Wolters Kluwer Tax & Accounting, gives examples of some common above the line deductions:

  • IRA contribution deduction.

  • Student loan interest deduction.

  • Alimony paid deduction for divorce or separation instruments executed on or before Dec. 31, 2018.

  • Health savings account deduction.

  • Educator expense deduction.

He also provides examples for deductions related to self-employment taxes:

  • Self-employed deduction (related to self-employment taxes).

  • Retirement contribution deduction.

  • Health insurance premium deduction.

But keep in mind that you calculate some deductions – like standard and itemized – after you determine your AGI.

The Standard Deduction

You have a choice between taking the standard deduction or itemized deductions.

"Today, nearly 90% of individuals take the standard deduction, which is a fixed amount based on filing status,” Weltman says. The IRS significantly increased the standard deduction in 2018.

For 2022 returns, the standard deduction is $12,950 for single filers, $19,400 for head of household, and $25,900 for married taxpayers filing jointly. Those 65 and older can claim an extra $1,400 deduction each if they're married filing jointly or $1,750 if they are single or filing as head of household.

“The standard deduction is not dependent on the expenses a person has and no record keeping is required,” Weltman says. You can take the standard deduction based on your filing status, no matter what expenses you have.

Itemized Deductions

Itemized deductions are based on specific expenses, such as charitable contributions, mortgage interest, state and local taxes (up to $10,000 per year) and medical expenses that are more than 7.5% of your AGI. You must keep proof of these expenses to claim the deductions.

To determine which type of deduction to take, add up your expenses that could qualify for itemized deductions and see if they equal more than the standard deduction. You can calculate and report itemized deductions on IRS Schedule A, which you file with Form 1040.

Keep in mind that if you take the standard deduction you won’t be able to take deductions for itemized expenses – and you can't deduct your 2022 charitable contributions. Those who didn't itemize could deduct up to $600 in charitable contributions in 2021 but that tax break expired and doesn't apply to 2022 tax returns.

Planning can help you make the most of the itemized deductions.

“Some people with itemized deductions that are somewhat close to the standard deduction can benefit from bunching itemized deductions, especially charitable contributions, every other year – taking itemized deductions in the bunched year and the standard deduction in the year with lower itemized deductions,” Luscombe says.

“For example, you could make your annual charitable contributions in January and December of the same year and make no charitable contributions the following year. Taxpayers might also be able to bunch elective medical deductions. The tax law limits bunching mortgage interest and state taxes," he adds.

Different Types of Tax Credits

Tax credits reduce your tax liability dollar for dollar.

“In recent years, more and more tax breaks are in the form of tax credits,” Weltman says.

“For example, homeowners can claim credits for making certain energy efficient improvements to their homes and consumers can claim credits for buying electric vehicles if they qualify. There are credits to help pay for health insurance (the premium tax credit) child care (dependent care credit) and more,” she says.

The value of the credit doesn’t vary based on your tax bracket but some tax credits are worth different amounts based on your income.

For example, the retirement savings contribution tax credit (also known as the saver’s credit) is worth 0%, 10%, 20% or 50% of up to $2,000 in retirement savings plan contributions per person for the year, depending on your income. The lower your income, the larger the percentage.

Nonrefundable vs. Refundable Credits

There are two kinds of tax credits: nonrefundable and refundable. All tax credits reduce your tax liability but the difference lies in whether you can get back more than your total taxes for the year.

Most tax credits are nonrefundable, which means they can’t reduce your tax liability below $0 for the year. But some tax credits are refundable, which means you can get a refund even if the credit takes you below $0 tax liability.

“A nonrefundable tax credit is capped at the taxpayer’s tax liability. A refundable tax credit that exceeds the taxpayer’s liability is refunded to the taxpayer,” Luscombe says.

For example, Mark Steber, senior vice president and chief tax information officer for Jackson Hewitt Tax Service, says the child and dependent care tax credit is nonrefundable and you can't carry it over if there's any remaining credit after the tax liability is $0.

If you have two children and you’re eligible for a $2,100 dependent care credit based on your child care expenses but your tax liability is only $1,000, you’ll be able to get only up to $1,000 of the credit. (That credit was temporarily refundable for 2021 but not for 2022.)

But with refundable credits you’ll get the full amount and if it’s more than your tax liability, you’ll receive a refund. The earned income tax credit, additional child tax credit and 40% of the American opportunity tax credit (up to $1,000) are the most common refundable credits, Steber says.

Even if you aren’t required to file a tax return because your income is below the standard deduction, you still need to file one to claim the refundable tax credits.

“The IRS doesn’t send refunds automatically; taxpayers need to file returns to claim them,” Weltman says.

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