While both tax deductions and tax credits can save you a significant amount of money on your taxes, they work in significantly different ways.
What is a Tax Deduction?
A tax deduction is a result of a tax-deductible expense or exemption which reduces your taxable income. A common tax deduction on your federal income tax return is a personal exemption. An example of how this works: If your income was $50,000 your personal exemption would reduce your taxable income by the 2017 personal exemption of $4,050 so your taxable income would now be $45,950.
What is a Tax Credit?
Unlike tax deductions, tax credits are subtracted from your tax liability (not taxable income). A common tax credit is the child tax credit. If you have a qualifying child, you can take a credit of up to $1,000 per child against your tax liability in 2017. If besides the child tax credit, you would otherwise have a total federal income tax liability of $2,500, child tax credit for one child would reduce that tax liability to $1,500.
Which is better? A Tax Deduction or a Tax Credit?
If you were ever faced with a hypothetical choice between a $100 tax deduction and a $100 tax credit, you would want the credit. Unlike a tax deduction, a $100 tax credit reduces your tax dollar-for-dollar ($100). On the other hand, a tax deduction reduces your taxable income by $100. The resulting amount of tax you save depends on your marginal tax bracket (in everyday language: your tax bracket). If you are in the 25% tax bracket in 2017, a $100 tax deduction reduces your taxes by $25.
Itemized Deductions vs. Standard Deductions
Just about everyone qualifies for the standard deduction. Although based on your filing status (e.g., single, married filing jointly, married filing separately, or head of household), all people with the same filing status receive the same standard deduction amount (the only exceptions are for the elderly, disabled, or blind – they receive a somewhat higher standard deduction).
By contrast, itemized deductions are numerous and their amounts vary by individual. Common itemized deductions include:
There’s a bit of a hitch with itemized deductions, however. You can only benefit from itemized deductions to the extent they exceed your standard deduction ($6,350 if you are single and $12,700 married filing jointly in 2017). Said another way, each taxpayer is permitted to take the higher of either their standard or itemized deductions – but not both.
Say you are married and filing jointly and your standard deduction is $12,700. When you add up the total of your itemized deductions you get $12,800. Since your itemized deductions exceed your standard deduction by $100, you get to take the itemized deduction. So, it really pays to remember every additional deductible expenses that may bump you up over the standard deduction, such as charitable contributions and unreimbursed employee expenses.
Whether an expense qualifies for an income tax deduction or a tax credit, you want to take advantage of every opportunity to lower the taxes you’ll pay! I often find deductions or credits my clients hadn't realized they could take. I'd love to help you find tax savings you hadn't thought of too. Contact me today to get started on your 2017 tax return.
Hi! I'm Jaimie and I have a B.A. in Accounting, an MBA with an emphasis in Accounting and a CPA license. I worked for about 10 years in CPA firms doing audits and reviews and then for about 10 years in private companies managing accounting departments. I've learned a lot about accounting, finances and taxes over the last 20 years! And now I want to share my knowledge with you here!