Tax credits and tax deductions can both reduce what you owe in taxes each year, but they work differently.
Deductions can reduce the amount of income you have to pay taxes on, which can lower your final bill. Tax credits are a dollar-for-dollar reduction in what you owe — and might even get you a bigger tax refund.
It’s possible to qualify for tax credits and tax deductions, but it’s important to know how both options work.
What Are Tax Credits?
Tax credits represent a dollar-for-dollar reduction in your overall tax burden. They directly lower the tax amount you owe to Uncle Sam.
For example, if you owe $1,500 in taxes but qualify for a $500 tax credit, your total tax bill will decrease by $500, meaning you’ll only have to pay $1,000.
Feeling Lost? Check out SoFi’s Tax Season Help Center.
How Do Tax Credits Work?
When filing your taxes, you can use IRS resources, tax software, or a certified accountant to research tax credits for which you may be eligible. If it’s your first time filing taxes, these resources can be especially helpful.
Even if you don’t owe anything in taxes, it’s worth looking into tax credits. Why? Because some tax credits are refundable, meaning the government might owe you money:
• Refundable tax credits allow your tax liability to go below zero. For example, if you owe $100 in taxes but receive a $500 refundable tax credit, the government will actually owe you $400.
• Nonrefundable tax credits do not work that way, unfortunately. If you qualify for a nonrefundable tax credit, the best it can do is eliminate your tax liability (meaning you owe nothing). But even if the credit is large enough to wipe out what you owe and there’s still money left over, you don’t get to pocket that extra money.
Tax credits are not for everyone. Each credit has specific requirements to qualify.
And if you’re wondering what happens if you miss the tax deadline, tax credits would still apply for the year that you’re filing your taxes.
Common Tax Credits
Your tax software or accountant should know the full list of tax credits to look out for, and the IRS website features the whole list. Before diving into your taxes, however, it’s a good idea to note some of the most common tax credits for which you may qualify:
• Earned Income Tax Credit: Commonly called by its initials (EITC), this refundable tax credit is for low- to moderate-income workers. The amount you might qualify for and your eligibility can vary depending on whether you have dependents and/or have a disability.
• American Opportunity Tax Credit: This education tax credit is partially refundable. Students (or parents claiming a student as a dependent) can claim this tax credit for the first four years of higher education. It’s $2,500 per eligible student, but once your tax bill hits zero, you can earn 40% of whatever remains (up to $1,000) as a tax refund.
• Child Tax Credit: Even if a child isn’t enrolled in higher education, parents have access to a handy tax credit. The Child Tax Credit is a refundable tax credit for parents (with dependent children) who meet income requirements.
• Child and Dependent Care Credit: Parents have access to yet another potential tax credit, this time for those who pay for babysitters or daycare. The credit amount depends on your income, child care costs, and number of children requiring care. Prior to the 2021 tax year (filed in 2022), this was nonrefundable, but the American Rescue Plan Act made it refundable.
You can use tools on the IRS website to discover if you qualify for these and other tax credits.
Recommended: Do I Need a Personal Accountant?
What Are Tax Deductions?
Tax deductions are another way to reduce your tax burden, but they work differently. While a tax credit discounts your final tax bill after all the calculations, a tax deduction reduces the amount of income eligible for taxes.
The more deductions you have, the less money you have to pay taxes on. This can result in a lower overall tax bill, but it cannot result in a tax refund.
Recommended: What Triggers an IRS Audit?
How Do Tax Deductions Work?
Let’s look at an example to understand how tax deductions reduce what you owe:
If you made $100,000 in a given year, you would owe 24% in federal taxes based on your marginal tax bracket, or $24,000. But if you have $10,000 in tax deductions, you instead only owe 24% of $90,000, which is $21,600.
In this example, your total tax deductions equal $10,000 — but they reduce what you owe by just $2,400.
In calculating how much a tax deduction will save you, it’s important to know which tax bracket you’re in — your tax bracket represents the percentage at which your income will be taxed. In general, the more money you make, the higher the tax rate.
Common Tax Deductions
Nearly every tax filer is eligible for the standard deduction. Without inputting any information accounting for business expenses, medical costs, charitable contributions, student loan interest payments, and other eligible deductions, you can simply subtract the standard deduction amount from your taxable income.
For the 2022 tax year (which will be filed in April of 2023), the standard deduction is:
• $12,950 for single taxpayers (and married, filing separately)
• $25,900 for married taxpayers filing jointly
• $19,400 for heads of household
Many people choose to take the standard deduction, but if you qualify for various deductions that would amount to more than the standard deduction, it’s worth itemizing your deductions.
An accountant or tax preparation software may be your best bet for determining which deductions you qualify for. Here are some of the most common types of deductions:
• State and local taxes
• Business expenses (if you are self-employed)
• Mortgage interest
• Property taxes
• Qualifying medical expenses
• Charitable contributions
• Student loan interest
• Gambling losses
You can explore even more tax deductions on the IRS website.
If you run your own business, check out these common tax deductions for freelancers.
Pros and Cons of Tax Credits
Tax credits are largely a good thing, as they reduce your overall tax burden. But they also have some drawbacks. Let’s look at the pros and cons:
• Reduces your tax bill
• May result in a refund
• Often designed for moderate- to low-income families
• Strict eligibility requirements
• Can delay your refund when you claim them
Recommended: How to File for a Tax Extension
Pros and Cons of Tax Deductions
Similarly, tax deductions serve a useful purpose in filing taxes, but they also have their own set of pros and cons:
• Reduces your tax bill
• The standard deduction is easy to claim
• Useful for self-employed individuals with business expenses
• Lots of paperwork (itemized deductions)
• Weighing the standard vs. itemized deduction can be complicated
• Won’t generate a refund
Recommended: How to Prepare for Tax Season
Tax Credits vs. Deductions: What’s the Difference?
Let’s break down the differences between tax credits and tax deductions:
|Tax Credits||Tax Deductions|
|Dollar-for-dollar reduction in your total tax bill||Reduction in how much income you have to pay taxes on|
|Can result in a tax refund||Can only reduce taxable income; cannot result in tax refund|
|Must claim specific credits for which you qualify||Can take the standard deduction or itemize your deductions|
|Only available to filers who meet specific criteria||Available to most filers as standard deduction|
While nearly everyone can qualify for the standard deduction, tax credits are actually the
more effective way to lower your tax bill. But the best part? You can utilize both tax strategies when you file.
Tips for Using Tax Credits and Deductions
Ready to file your taxes? Here are some tips for using tax credits and deductions:
• Research eligibility requirements online: The IRS website has useful tools to help determine if you qualify for specific tax credits and deductions.
• Gather all your paperwork: Taxes require a lot of forms, documents, and receipts. When claiming credits and deductions, it’s important to have the paperwork (whether printed or digital) to prove your eligibility.
• Consider using tax software or an accountant: Taxes can be overwhelming. If your situation is complex, you may benefit from tax software or a tax professional.
Recommended: Types of Payroll Deductions
Tax credits and tax deductions can both lower your overall tax burden. Tax credits reduce what you owe dollar-for-dollar while tax deductions reduce the amount of income you owe taxes on. If you’re eligible, you can take advantage of both tax strategies when you file.
3 Money Tips
1. Direct deposit is the fastest way to get an IRS tax refund. More than 9 out of 10 refunds are issued in less than 21 days using this free service, plus you can track the payment and even split the funds into different bank accounts.
2. An emergency fund or rainy day fund is an important financial safety net. Aim to have at least three to six months’ worth of basic living expenses saved in case you get a major unexpected bill or lose income.
3. If you’re faced with debt and wondering which kind to pay off first, it can be smart to prioritize high-interest debt first. For many people, this means their credit card debt; rates have recently been climbing into the double-digit range, so try to eliminate that ASAP.
Between a tax deduction and tax credit, which lowers your bill more?
A tax credit lowers your tax bill dollar-for-dollar and may even result in a refund. A tax deduction only reduces the amount of money you owe taxes on. For example, a $1,000 tax credit takes $1,000 off your tax bill. A $1,000 tax deduction reduces your taxable income by $1,000; the actual reduction in tax depends on your tax bracket.
Do more people utilize tax credits or tax deductions?
Most tax filers can claim the standard deduction, but not everyone qualifies for tax credits. Thus, it is more likely that you’ll use a tax deduction on your tax return than a tax credit. That said, it is possible to use both credits and deductions to lower your tax bill.
Can I claim both deductions and tax credits?
Yes, you can claim both tax deductions and tax credits on your tax return, as long as you qualify for the deductions and credits you claim.
Photo credit: iStock/Jinli Guo
SoFi members with direct deposit can earn up to 3.75% annual percentage yield (APY) interest on Savings account balances (including Vaults) and up to 2.50% APY on Checking account balances. There is no minimum direct deposit amount required to qualify for these rates. Members without direct deposit will earn 1.20% APY on all account balances in Checking and Savings (including Vaults). Interest rates are variable and subject to change at any time. These rates are current as of 12/16/2022. Additional information can be found at http://www.sofi.com/legal/banking-rate-sheet
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.