Which one will save you more?

Although paying taxes is a fact of life, the IRS offers taxpayers the opportunity to reduce their debt through a variety of tax credits and deductions. But it’s not as simple as it seems. To qualify for each deduction or credit, you must meet certain criteria. While both deductions and credits can reduce taxes, the way they affect your overall tax bill and potential tax refund can be very different.

Here’s what you need to know about the differences between tax deductions and tax credits and how they can help you reduce your tax bill and maximize your tax refund.

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Tax Deduction and Tax Credit — What Does It Mean for Your Tax Refund?

The main difference between a tax credit and a tax deduction is that a credit reduces the amount of tax you owe, while a deduction reduces your taxable income.

How Does the Tax Credit Affect Your Refund?

It’s easy to measure the value of a tax credit because each dollar of credit reduces your tax liability by one dollar. For example, if your tax liability for the year is $10,000 but you have a $2,000 tax credit, your tax liability drops to $8,000. If your liability was $2,000, a $2,000 loan would reduce it to $0.

What this means for your refund depends on how much tax you paid during the tax year. If you had paid the entire $10,000 tax liability by withholding tax from your paycheck, you would receive a $2,000 refund. On the other hand, if only $8,000 was deducted, you wouldn’t owe any additional taxes, but after applying the credit you won’t get a refund because you’ll have paid the amount you owe.

How Does Tax Deduction Affect Your Refund?

How a tax deduction affects your refund depends on your tax bracket, because a tax deduction only reduces your taxable income.

tax brackets seven tiers of income to which a certain tax rate applies. The tax brackets for 2024 are as follows:

Your tax bracket is the bracket that applies to your last dollar of earnings. So, if you have $40,000 in income, you’re in the 12% tax bracket; The first $11,000 is taxed at 10%, and your income between $11,001 and $40,000 is taxed at 12%.

The tax rate on the last dollar you earn (12% in this example) is your marginal tax rate. The higher your marginal tax rate, the larger your potential refund.

To find out how much a deduction saves you, multiply your marginal tax rate by the deduction amount. For example, if you can deduct $7,000 for contributions to a traditional IRA and you fall into the 12% tax bracket, multiply $7,000 by 0.12 to find that the deduction saves you $840 on your taxes. If you were in the 32% tax bracket that tax year, that same $7,000 deduction would save you $2,240.

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What are Tax Deductions?

tax deductions deleted ones You use it to reduce your taxable income before calculating how much tax you owe. For example, if you earn $55,000 but qualify for a $1,000 tax deduction, your taxable income drops to $54,000..

Deductions allowed by the IRS include adjustments to income and the choice between the standard deduction and itemized deductions.

Adjustments to Income

Regardless of whether you claim the standard deduction or itemize your deductions, you can claim adjustments to income, sometimes called “above-the-limit” deductions. Adjustments to income include:

Standard Deduction and Itemized Deductions

The standard deduction makes it easier to pay your taxes because it’s a fixed amount—$14,600 for individual filers ($29,200 for married joint filers)—with no worksheets, schedules, or calculations required on your part. But some taxpayers make a bigger profit by itemizing deductions.

Itemized deductions are individual expenses that the IRS allows you to deduct from your taxable income. Some of the more common ones include:

• charitable donations

• gambling lossesas much as your earnings

• Medical expenses exceeding 7.5% of your adjusted gross income

• mortgage interest

• Property tax up to certain limits

Each year, you must decide whether to itemize your deductions or take the standard deduction.

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What is Tax Credit?

A tax credit is the amount subtracted directly from the amount of tax you owe. For example, if you owe $4,000 in taxes and qualify for a $1,000 tax credit, you will only owe $3,000 in taxes.

Tax credits fall into three categories: refundable credits, partially refundable credits, and non-refundable credits.

Refundable Credits

Refundable credits allow for a full refund if the credit reduces your tax liability below $0. For example, let’s say your total tax liability for the year is $1,500. If you have a $2,000 refundable tax credit, you’ll get a $500 refund. If your tax liability is $0, you’ll receive the full $2,000 in refund.

Examples of refundable tax credits include:

Partially Refundable Credits

A partially refundable credit allows a portion of the credit to reduce your tax liability below $0, so it can be refunded to you even if you don’t owe taxes. child tax credit is a good example. While there are technically two credits, one refundable and the other non-refundable, the IRS considers this a partially refundable credit.

The nonrefundable child tax credit is worth $2,000 per eligible child in 2024. If you can’t claim the full amount, you can claim the “additional child tax credit” and have $1,700 of your $2,000 credit refunded to you.

So if you qualify for the $2,000 child tax credit and your tax liability is $4,000, the credit would reduce your tax liability to $2,000. If your tax liability is $0, the additional child tax credit kicks in, reducing your taxable income to -$1,700, effectively refunding all but $300 of the child tax credit.

Non-Refundable Loans

Non-refundable credits can only be used to reduce your income taxes to $0. Once your total annual taxes reach $0, nonrefundable credits can’t increase your refund any further. So if you owe $4,000 in taxes but have $5,000 in credits, the credits would reduce your tax liability to $0.

Popular non-refundable tax credits include:

• Child and dependent care loan

• Lifelong learning credit

• Loan for other dependents

• savings loan

• Energy efficient home improvement loan

Who Benefits Most from Tax Credits and Tax Deductions?

Tax credits provide the most benefit to low- and moderate-income taxpayers. This is because many loans have income limits and lower income means lower tax liability or even no tax liability. Refundable and partially refundable credits, such as the earned income and child tax credits, provide refunds to these taxpayers even if they have not paid or overpaid the tax.

Tax deductions, on the other hand, benefit high-income taxpayers by reducing taxable income. If deductions reduce taxable income enough, they could put the taxpayer in a lower tax bracket. In this case, the taxpayer achieves additional savings by paying a lower tax rate on his already reduced taxable income.

Upcoming Tax Changes to Watch Out for

The IRS makes changes each year that may: affects your tax liability. Here are some of the changes the IRS has announced so far for 2025:

• The standard deduction will increase by $400 to $800, depending on your filing status.

• The tax brackets remain the same, but marginal tax rates within each bracket apply to higher amounts of income; This could reduce taxes for some taxpayers and prevent others from falling into higher tax brackets.

• The earned income tax credit increases by $216.

• Alternative minimum tax increase exemptions that help more taxpayers avoid it.

Strategies to Maximize Your Tax Credits and Deductions

Taxes are inevitable for most Americans, but you can ease their burden by taking steps to maximize credits and deductions.

• Research tax deductions and credits to find out what you’re eligible to claim. IRS website, HereIt is an excellent resource.

• Keep accurate financial records and organize deductible and credit-eligible expenses by category. Add them up at the end of the year so you know whether to take the standard deduction or itemize your deductions.

• If you’re married, calculate your tax liability separately and jointly to see which is most beneficial.

• Deposit the full allowable amount into your tax-deferred retirement accounts and flexible or health savings account

• Plan for potentially deductible year-end expenses, such as mortgage payments (for mortgage interest), medical expenses, business expenses, and charitable contributions, for when they will benefit you the most (at the end of this year or the beginning of next year). .

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Daria Uhlig Contributed to the reporting of this article.

Last update: November 4, 2024

This article was first published on: GOBankingRates.com: Tax Credits or Tax Deductions: Which Will Save You More?