Tax Deductions vs Tax Credits

person doing taxes

Tax refunds will be smaller in 2023 than they were in 2022. Since you’ll be getting less money back, take advantage of any tax credits or deductions to reduce your tax liability and keep more money in your pocket.

But the question of which is better for your situation—a tax deduction or a tax credit—is complicated. Knowing the difference will help you understand what you’re qualified for and how much you can save. Here’s a breakdown of tax credit vs deduction and how to take advantage of both.

Tax Credit vs Deduction

Tax credits and tax deductions lower the amount of taxes you owe, but they have different effects on your overall tax liability. With a deduction, the government allows you to subtract an amount from your taxable income. The result is that you’ll be paying less in taxes than if there weren’t any deductions at all.

A credit reduces the tax payments owed to federal and state governments. For example, if you owe $100 in taxes but qualify for a $200 tax credit, the government won’t require you to pay taxes.

Types of Tax Credits

Tax credits are easier to file than tax deductions, but you’ll still need to check with your accountant or the IRS website to make sure you’re getting it right. A common tax credit example is the Electric Vehicle Tax Credit. It’s a nonrefundable credit for taxpayers who purchase specific electric cars.

The refundable credit is, however, just one of three types of tax credits. Here’s a quick breakdown of them all.

Refundable Tax Credit

If you claim a refundable credit and the amount of that credit is larger than what you owe in taxes, the government will send you a check for your balance. Even if a taxpayer doesn’t owe taxes, they can still apply for refundable tax credits and receive the amount of the credit.

Nonrefundable Tax Credit

A nonrefundable tax credit is one where you can’t receive a refund if the total value of the credits exceeds your tax bill. The excess money also won’t roll over to the following year’s tax bill.

Partially Refundable

If you have no tax liability after using a partially refundable credit, then 40% of the remaining amount will be refunded to you. The American Opportunity Tax Credit, which helps families pay for college expenses, is an example of a partially refundable credit.

Types of Tax Deductions

Most taxpayers can choose to take the standard deduction or itemize their deductions.

The standard deduction is a fixed amount that’s subtracted from your income before taxes are calculated. The amount varies based on your filing status and is adjusted for inflation each year.

Itemized deductions are specific expenses that reduce your taxable income. Examples of itemized deductions include medical expenses, charitable contributions, and mortgage interest paid on your primary residence.

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When it comes to tax credit vs deduction, neither is better than the other. Your situation will determine which will save you the most money. The good news is that you don’t have to choose between using one or the other, so take advantage of both when it’s time to file your taxes.

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