Deductions and credits—you probably know they’re both things that can save you money on your tax return, but what’s the difference? We dive into that below.
What’s a tax deduction?
First, let’s tackle deductions. A tax deduction is an expense or exemption that helps to reduce your taxable income. One of the most common deductions on the federal return is the standard deduction, which reduces your taxable income based on how much you made. For instance, if you reported $50,000 income, you could take a standard deduction of $12,950, lowering your taxable income to $37,050. Now you only have to pay taxes on $37,050, not the full $50,000.
What’s a tax credit?
While deductions are subtracted from your taxable income, credits get subtracted from your taxes owed. One common tax credit is the Child Tax Credit, which can reduce your taxes owed by up to $2000 for each child under age 17 who is dependent on you.
Deduction or credit: which is better?
So to recap, the main difference between deductions and credits is that one (deductions) is subtracted from your taxable income and the other (credits) is subtracted from your taxes owed. Both end up saving you money on your taxes, but the way they do that is different.
Because of this difference, credits are a dollar-for-dollar subtraction from what you owe, whereas deductions work a little differently. If you received a $100 credit, you’d pay $100 less in taxes. By contrast, if you received a $100 deduction, that would reduce your taxable income by $100. You would save some money on your taxes owed as a result, but the final number would depend on your tax bracket, or the rate at which you were taxed based on your income. (For example, if you were in the 15% tax bracket and got a $100 deduction, you’d have to pay $15 less in taxes.)
For this reason, credits tend to save you more money than deductions, and so if you had to choose between taking a deduction or a credit, you’d generally want to go with the credit.
What’s the difference between itemized and standard deductions?
When you take deductions on your tax return, you can choose either the standard or itemized deduction. Almost everyone will qualify for the standard deduction, though the final amount of said deduction will vary based on whether you’re filing singly, jointly, married separately, or as head of household.
Itemized deductions, on the other hand, will vary. Things you can itemize include:
- Medical expenses that fall above 7.5% of adjusted gross income
- State income taxes
- State sales and local taxes
- Property taxes
- Student loan interest
- Mortgage interest
- Charitable donations
While a standard deduction is simply one lump sum, itemized deductions allow you to deduct each cost separately, which may end up saving you more. You’re allowed to take whichever method you want, but you have to choose one or the other. It goes without saying that it makes sense to use whichever will save you more, though you may not know which that is until you calculate all your possible deductions.
There you have it: now you know the difference between deductions and credits, and between standard and itemized deductions. Hopefully, you can use this knowledge to save the most money possible on your next tax return.