It’s tax season, folks. And for many of us, that means an extra dose of stress when it comes to organizing our finances and getting a refund.
However, by understanding how a tax credit vs. tax deduction works, you can get a better handle on your tax refund situation.
Plus, once you know the differences between the two, it’s a little easier to make decisions as you plan out your finances for the coming year. Here are six basic questions about both topics you need to know the answers to.
1. What is a tax deduction?
Simply put, a tax deduction is a way to reduce your income before your taxable income is determined.
That’s why it’s important to figure out what your taxable income is based on your effective tax rate. Especially since gross income isn’t the same thing as your taxable income.
What’s more, your taxable income is generally lower than what you see in your paycheck. This is because a tax deduction is a way for you to subtract some of your expenses from your income.
Ultimately, the taxes you owe are based on your taxable income, which is found on Line 43 of the Form 1040. Everything you do before Line 43 is all about reducing your taxable income.
2. How do you make an “above the line” tax deduction?
One of the most common terms you hear when talking about taxes is “above the line.” Basically, everything on the first page of your Form 1040 is considered above the line. These are tax deductions that you don’t have to itemize.
Items like moving expenses, student loan interest, and contributions to your Health Savings Account or Traditional IRA are included as above the line deductions. Make sure you double-check with a tax professional that you are eligible to take these tax deductions.
3. What are itemized tax deductions?
Once you get past the first page of your Form 1040, you have the chance to further reduce your income through other deductions.
First off, there’s the standard deduction, which the Internal Revenue Service (IRS) adjusts based on inflation rates.
For the 2016 tax year, the standard deduction is $6,300 for singles (and married couples filing separately), or $12,600 for married filing jointly. There’s also a standard deduction of $9,300 for someone filing as head of household.
But it’s not always in your best interest to take the standard deduction. In some cases, itemizing your deductions makes more sense. When you itemize, carefully record all your eligible expenses on Schedule A and send it along with your Form 1040.
Some of the expenses that can be itemized include state and local taxes you paid, mortgage interest paid, and charitable contributions. Depending on certain requirements, you can also deduct the medical and dental expenses you pay out of pocket, as well as job search costs.
Review your eligibility to see which itemized deductions you can take. Then, see if your itemized deductions add up to more than the standard deduction.
Ultimately, you will have to choose between the standard deduction and itemized deductions. Figure out which will reduce your income by more then proceed accordingly.
4. How do tax credits work?
Now that you know the answer to the question, “What is a tax deduction?” it’s time to tackle tax credits.
The cool thing about a tax credit is that it is a dollar-for-dollar reduction in the tax you owe. It’s like a gift card that you apply to your tax bill to make it smaller.
A tax credit is best figured out after you know how much you owe in taxes and what your taxable income is based on Line 43 of your Form 1040 (pictured below). Then, use that information to calculate your marginal tax rate and check the tax table to see how much you owe in taxes.
Make sure you claim all of your applicable tax credits on Lines 46 through 54, add them all up, and list the total on Line 55. Then, apply that total to what you owe to bring down your tax bill. Things like education credits, the Earned Income Credit, and dependent care credits are all included in this section (pictured below).
5. What are refundable vs. non-refundable tax credits?
There are different types of tax credits, though.
For instance, some tax credits are refundable. So if your tax credit puts you beyond what you owe in taxes, you get the excess back.
The Earned Income Credit is an example of this type of refundable credit. If you owe $3,000 in taxes, but you have refundable credits that add up to $4,000, you get $1,000 back. Not too shabby, right?
However, there are also non-refundable credits. These tax credits include items like the child tax credit and the foreign tax credit. These credits can only bring your tax bill down to $0. So if you have non-refundable credits in excess of what you owe, you miss out.
There are also partially refundable tax credits. The American Opportunity Tax Credit (AOTC) is a good example of one of these. Once you hit $0 due to this credit, you can receive 40 percent of the remaining amount as a tax refund, not surpassing a limit of $1,000.
Say you owe $500 in taxes and you are eligible for the full $2,500 for the AOTC. However, the tax bill only goes down to $0, and there’s still $2,000 remaining of the AOTC you’re eligible for.
Instead of receiving the full $2,000, you get $800 refunded to you (which is 40 percent of $2,000). You don’t get the total amount left, but you do get something.
6. Combine tax deductions and credits for best results
Your tax strategy should include tax deductions and tax credits in order to get the best tax filing results possible.
And understanding the difference between tax credit vs. tax deduction can help you structure your spending in a way that maximizes your tax breaks.
That’s why it’s important to look ahead to your expenses for the year. Then, see if you can plan your finances in a way that allows you to take advantage of income reductions and items that directly reduce the taxes you owe.