It’s TaxTipTuesday. Hey, I’m Bette Hochberger, CPA, CGMA. And today, we’re talking about the difference between a tax deduction and a tax credit. People often don’t know the difference. They don’t realize these are two different things, but they are.
The simplest way to explain it: a tax credit, dollar for dollar, reduces your tax liability. So, for example, if you owe a hundred dollars in taxes and you have a hundred-dollar tax credit, you would owe zero in taxes, right? So the tax credits will eliminate those taxes well, eliminate up to the dollar amount that you have a credit, the taxes that you owe. Now, a deduction, on the other hand, reduces your taxable income, right? So if you’ve got, say, $20,000 in medical expenses and charitable donations and state income tax and real estate tax and all those things, if you’ve got that, you’re going to offset your income by the amount of money. So then, you’re going to calculate the tax after that. So you reduce your taxes, yeah, but it’s not dollar-for-dollar because a tax calculation is a little bit complicated. So maybe that’s another TaxTipTuesday.
Now, beyond that, there’s another layer. So when we talk about tax deductions, you might hear people say “I itemize” or “I take the standard deduction,” right? So you have that difference there, and you’re allowed to take whichever is more beneficial to you: thank you, IRS. They don’t often throw us a bone like that, but, on this, they happen to let us take advantage of the tax code a little bit. So tax deductions can either be itemized deductions, which is your medical expenses subject to that floor, which is again, another whole topic, state income tax, real estate taxes, mortgage interest, charitable donations. Those are the big ones. Those are the main ones. And if you don’t want to keep those records, or if you don’t have enough, you can take the standard deduction, and you don’t have to worry about any of that, but only do that if it’s to your benefit. So if you’re better off keeping track of all those things, do it. Save money on taxes.
Now, tax credit, on the other hand, right; there are two main kinds. You’ve got a refundable tax credit, any non-refundable. So what does that mean? It’s a little obvious once you know. So a non-refundable tax credit means it will not reduce your taxes down past zero. But if it’s a refundable credit, like earned income tax credit is a refundable credit, you can take your taxes, the income taxes you owe below zero, and generate a refund. So that’s a refundable tax credit. It makes sense once you know what it is.
So in all, if you have an option, for some reason, you could take one or the other. You want the credit because the credits are better; It’s like getting free money. But yeah, we’ll take deductions, too. It’s all good. It all lowers our taxes. So I hope that explains a little bit between the differences: tax credits, tax deductions. If you have any further questions, drop them in a comment below, and we’ll see you next time.