Reducing the amount of money you owe in taxes is always an admiral opportunity. Tax credits and tax deductions are two of the ways to reduce this number, although they are not identical opportunities. There are key differences between them in how they work to reduce your total tax liability.
Tax deductions reduce your taxable income. That is, the amount of your income that gets taxed by the federal government. Reducing this taxable income therefore reduces the amount of taxes that you have to pay for a certain year. The most common form of tax deductions is the standard deduction. The amount of your standard deduction is dependent on your filing status and is adjusted every year.
Other available deductions are listed on the IRS Schedule A and Schedule 1 on Form 1040. Many tax deductions do come with certain eligibility rules and restrictions. So, you can’t automatically claim all deductions on your tax return. Be sure to confirm qualification rules with the IRS or a professional tax preparer. Deduction amounts also vary depending on the limit or size of particular deductions. For instance, deduction limits for Traditional IRA and HSA contributions is $6,000.
Tax Credits directly lower your tax liability, on a dollar-for-dollar basis. For example, if you end up owing $6,000 in taxes this year and are eligible for a tax credit of $2,000, then your tax credit would lower your tax bill to $4,000. Contrary to tax deductions, the value of tax credits is not tied to your income tax bracket, so a $2,000 credit is worth exactly $2,000 when it comes to how much you save on your taxes. As is the case with tax deductions, you will not qualify for all tax credits you come across, so you must get details from the IRS or a professional tax preparer for any credits that you would like to claim.
There are two types of tax credits: refundable and nonrefundable. Refundable tax credits simply mean that any unused amount of the credit will be refunded to you. However, with a nonrefundable tax credit, the amount of taxes you owe can only be reduced up to the amount of your tax credit. Any portion of the tax credit that remains unused won’t be refunded to you. For instance, if you owe $500 in taxes and have a $2,000 nonrefundable tax credit you qualified for, you could use $500 of that credit to bring your tax bill to zero. But the unused $1,500 would be forfeited.
It is important to remember that in order to claim tax deductions and tax credits, many eligibility requirements are present. These requirements mean that the IRS expects certain documentation to be provided with your tax return to show that you are indeed qualified to claim them. So, it is important to partake in good tax recordkeeping as well as maintaining contact with the IRS, or a tax professional should you be unsure about a deduction or credit.