Every industry and profession has common terms that are used so often those of us in the business often forget that most people do not have the depth of understanding that a person working within the tax code might have. One of these areas is understanding the differences between the tax terms “deductions” and “credits”. Is one better than the other?
Tax credits are some of the most valuable tools around to help cut your tax bill. But figuring out how to use these credits on your tax return can get complicated very quickly.
Here’s an easy-to-follow breakdown.
Dollar for dollar, a credit is worth more to you than a deduction. Why? A credit is a direct reduction in tax, while a deduction reduces the amount of income that gets taxed. Here is a simple chart showing the difference.
Assuming you have a $2,000 tax credit, how large a deduction would you need to be indifferent?
| Your marginal tax rate | Deduction required to equal $2,000 tax credit |
| 10% | 20,000 |
| 15% | 13,333 |
| 25% | 8,000 |
| 28% | 7,143 |
| 33% | 6,061 |
| 35% | 5,714 |
Note: This example does not account for the possibility that the deduction could move you into a lower tax rate nor does it consider other tax factors.
To help illustrate the difference between a credit and a deduction, here is an example of a single taxpayer making $50,000 in 2022.
In this example, your tax credit is five times as valuable as a tax deduction.
So on the surface it appears that a credit is worth more than a deduction to you. But the real answer is….it all depends. Here are some things to consider:
A similar deduction is worth more to someone in the 35% tax range than it is to someone being taxed at 10%.
A large deduction could be worth more to you than a small credit. In combination with your marginal tax rate, a deduction could be worth a lot more to you than a credit.
Most credits and deductions phase out when your income is over certain amounts. You must consider this when determining the true tax benefit. Consider that a deduction that reduces your income could make other credits and deductions that were previously phased out now available to you.
Some credits get a “bonus”. While you cannot deduct your income below zero, you can sometimes receive credits that create a refund even if you owe no tax. Credits that have this “bonus” feature are called “refundable” credits.
Included for your reference are some of the more common deductions and credits. Thankfully, professional tax software allows for quick analysis of the choices.
| Common Credits | Common Deductions |
|
|
Note: Many of these credits and deductions are not a permanent part of the tax code. Some have been repeatedly extended while others have or will expire without congressional action.
Credits are generally worth much more than deductions. However there are usually several hurdles you have to clear before being able to take advantage of a credit.
To illustrate, consider the popular child tax credit from last year.
You were able to claim a $2,000 tax credit for each qualifying child you have on your 2022 tax return. The good news is that the IRS’s definition of qualifying child is fairly broad, but there are enough nuances to the definition that Hurdle #1 could get complicated. And then to make matters more complicated…
If you make too much money, you can’t claim the credit. If you’re single, head of household or married filing separately, the child tax credit completely goes away if you exceed $240,000 of taxable income. If you’re married filing jointly, the credit disappears above $440,000 of income. And then to make matters more complicated…
To claim the entire $2,000 child tax credit, you must owe at least $2,000 of income tax. For example, if you owe $3,000 in taxes and have one child that qualifies for the credit, you can claim the entire $2,000 credit. But if you only owe $1,000 in taxes, the maximum amount of the child tax credit you could claim is $1,400.
While this child tax credit is just one example to help highlight the difference, it also applies to other popular credits such as the Earned Income Tax Credit, the Child and Dependent Care Credit, education credits, the new Clean Vehicle Credit, and many more.
The bottom line is that tax credits are usually more valuable than tax deductions. But tax credits also come with lots of rules that can be confusing. Please call to schedule a tax planning session to make sure you make the most of the available tax credits for your situation.
Empowering business owners and individuals in South Jersey and Philadelphia to feel confident through proactive accounting and advisory solutions.
