3.4 Tax Credits and Deductions - 3.4 Tax Credits and Deductions Explained
Key Concepts
- Tax Credits
- Tax Deductions
- Difference Between Credits and Deductions
- Common Tax Credits and Deductions
Tax Credits
Tax credits are direct reductions in the amount of tax you owe. Unlike deductions, which reduce your taxable income, credits reduce your tax liability dollar-for-dollar. This means that a $1,000 tax credit will decrease your tax bill by $1,000, regardless of your tax bracket.
For example, the Child Tax Credit allows eligible taxpayers to claim a credit of up to $2,000 per qualifying child. If you owe $5,000 in taxes and qualify for the full $2,000 Child Tax Credit, your tax liability would be reduced to $3,000.
Tax Deductions
Tax deductions reduce your taxable income, which in turn reduces the amount of tax you owe. The actual tax savings from a deduction depends on your tax bracket. For instance, if you are in the 22% tax bracket, a $1,000 deduction would save you $220 in taxes.
For example, the mortgage interest deduction allows homeowners to deduct the interest paid on their mortgage from their taxable income. If you pay $10,000 in mortgage interest and are in the 22% tax bracket, you would save $2,200 in taxes.
Difference Between Credits and Deductions
The primary difference between tax credits and deductions is how they reduce your tax liability. Credits reduce your tax bill directly, while deductions reduce your taxable income, which then reduces your tax bill based on your tax bracket.
Think of it like this: Tax credits are like receiving a coupon for a specific amount off your total bill at a store. Tax deductions, on the other hand, are like getting a discount on the items you buy before calculating the total bill.
Common Tax Credits and Deductions
Some common tax credits include:
- Earned Income Tax Credit (EITC): A refundable credit for low to moderate-income working individuals and families.
- American Opportunity Tax Credit (AOTC): A credit for qualified education expenses paid for an eligible student for the first four years of higher education.
Some common tax deductions include:
- Standard Deduction: A fixed amount that reduces your taxable income, depending on your filing status.
- Itemized Deductions: Deductions for specific expenses such as medical expenses, state and local taxes, mortgage interest, and charitable contributions.