How many times have you heard the terms “tax credit” and “tax deduction” being used while wondering if they mean the same thing? Well, let us clear that up for you.
The terms “tax credit” and “tax deduction” are often used to denote a decrease in the amount of tax you pay. Essentially, they translate into a hefty amount of savings. That being true, they still mean two very different things. Let us give you a lowdown on what these two widely misused tax terms actually mean –
A tax deduction is a resulting decrease in the total taxable income you achieve on making some tax-deductible expense or exemption.
There are Two types of tax deductions:
- Standard Deduction
- Itemized Deduction
Standard deduction is the portion of your income that is not subject to tax and which can be used to reduce the amount of your tax bill. You are eligible for standard deductions only if you do not itemize your deductions using Schedule A of Form 1040 on your taxable income.
The amount of standard deduction you are eligible for depends on your age, filing status, and also whether you are disabled or declared dependent on someone else’s tax return.
For the fiscal year 2018, the standard deduction for single individuals is $1200, $2400 for a married couple, and $18,000 for the head of a household.
Under the IRS, Itemized deductions are eligible expenses that individual taxpayers can claim on federal income tax returns. They reduce the taxable income and can be claimed in place of the standard deduction, if available.
There are numerous itemized deductions and their amounts vary as per the individual. Examples of Itemized deductions include certain dental and medical expenses below 7.5% of your gross adjusted income, State income taxes, State sales and local taxes, Property taxes, Charitable contributions, and even mortgage interest payments.
The catch with itemized deductions is that you can only enjoy the benefits attached with them if the amount you are eligible for exceeds your standard deductions amount.
This essentially means that you can enjoy either of the two – standard or itemized deductions, whichever is higher, but not both.
Tax credit, on the other hand, is the amount deducted from your net tax bill or tax liability. The amount of tax credit depends on the nature of the credit. Certain tax credits can be granted to an individual or business depending on their location, classifications, or industry.
Unlike tax deductions, tax credits reduce the actual amount of tax you owe and not your taxable income.
There are broadly three types of tax credits –
- Refundable tax credits
- Nonrefundable tax credits
- Partially refundable tax credits
Refundable tax credits :
Refundable tax credits are the most beneficiary credits, as they are entirely refundable. This essentially means that irrespective of the taxpayer’s income or tax liability, they are entitled to the entire amount of the credit.
What’s more is that this stands true even if the said credit reduces the tax liability to $0. Any further credit earns the taxpayer a refund.
The two most common examples of refundable tax credits include The Earned Income Tax credit and The Child Tax Credit. The Child Tax Credit became refundable in 2018, and is refundable up to $1,400.
Other refundable tax credits are for education and healthcare coverage.
Non-refundable tax credits:
Non-refundable tax credits are directly deducted from the tax liability of the concerned individual. This process continues till the tax liability gets reduced to $0. However, any further credit is unutilized. This means that no refund is initiated against the credit due beyond $0 tax liability.
This negatively impacts the lower income group as they cannot utilize the full amount. The non-refundable tax credits are only valid for the reporting fiscal year and expire once the tax is filed. Examples of non-refundable tax credits include credits for adoption, non-child dependents, mortgage interest payments, and foreign tax payments.
Partially refundable tax credits:
Partially refundable tax credits not only decrease the taxable income but also reduce tax liability.
American Opportunity Tax Credit is one such tax credit. Under this credit, if the taxpayer reduces their tax liability to $0 before taking the entire portion of tax credit, which is $2500, and the remainder may be taken as a refundable credit up to lesser of 40% of the credit or $1,000.
Thus, tax-related terms usually have more to them than meets the eye. To make well-informed decisions, My-Tax-Filer offers you personalized tax services. We have a team of well-trusted CPAs who are capable of handling all your woes.
Drop in an email at firstname.lastname@example.org or call us at (888)-482-0279 for all your tax related queries.