What the difference between tax deductions and tax credits and how do they work?
by: Anthony Parent
The primary tools the tax code uses to encourage taxpayers to take the actions that Congress wishes are tax deductions and tax credits. So what’s the difference? And which one is better? In this article we talk about the differences between the two and how they can work together to sometimes lower our taxes, and sometimes not.
How do Tax Deductions work?
First, let’s understand the general concepts of how you are taxed. You list your gross income, then you subtract out your deductions. From there we are getting close to calculating the taxable income on which some tax rate is applied.
Now there are two types of deductions and their names are derived from where you will find them on the a tax return.
Above the line deductions
Your adjusted gross income or AGI is the amount listed on the bottom line of page 1 of your tax return. It includes all of your total income, including wages, business and rental income, capital gains, unemployment income, and so on. It also factors in any allowances for personal exemptions and itemized deductions.
Above-the-line deductions, while commonly referred to as a deduction, are technically adjustments to your income. These adjustments include items such as traditional IRA contributions, moving and education expenses, alimony payments and the deductible portion of self-employment tax.
Above-the-line deductions can also refer to business deductions and losses. For example, a business expense reduces your net business income, which therefore reduces your total income.
Every dollar that reduces your AGI not only reduces your taxable income, but it may help you qualify for other deductions as well.
The interplay between deductions and credits
Various tax credits become limited by your adjusted gross income. In tax speak we saying they are “phasing out.”In some cases, a deduction may help you qualify for a credit or other tax perk that you would not receive otherwise. That is, in order to get some credits, your income needs to be below a certain threshold. If your income goes up or you lose deductions not only do you have a larger tax to pay but you also lose the credit and we are going to talk about why that is so important right now.
Understanding how tax credits work
What is worth more? A $10,000 tax deduction or a $10,000 tax credit. If you can take it, usually the tax credit is the better deal.
Suppose you had income of $100,000 and a tax rate of 20%. A $10,000 deduction will reduce your income to $90,000 so that you will owe $18,000 in taxes.
If you had a credit and no deduction, assume 20% of taxes on $100,000. There is no deduction so you are taxed on that full $100,000. So your taxes have gone up to $20,000. Now here is the difference. The credit acts like cash. So that it offsets dollar for dollar, dropping your $20,000 by $10,000 to a total tax bill of $10,000. You lost a deduction but paid less in taxes.
You see how easy it is to play these games to hide the true rate of taxation.
Now some credits you need income to offset while others you don’t. The kind of credits you need income to offset against are called non-refundable credits. A non-refundable tax credit is a tax credit that can only reduce a taxpayer’s liability to zero. Any amount that remains from the credit is automatically forfeited by the taxpayer.
Examples of Non-Refundable Tax Credits
The most commonly claimed tax credits are non-refundable. Examples are:
The Saver's Credit
Lifetime Learning Credit (LLC)
Child and Dependent Care Credit
Foreign Tax Credit (FTC)
Mortgage Interest Tax Credit
Elderly and Disabled Credit
Residential Energy Efficient Property Credit
General Business Credit (GBC)
Alternative Motor Vehicle Credit
Credit to holders of tax credit bonds
Some non-refundable tax credits, such as the general business credit and foreign tax credit, allow taxpayers to carry any unused amounts forward to future tax years (time limits apply to the carryover rules).
Unlike a nonrefundable credit cannot which usually not result in a refund, a a refundable tax credit can continue to reduce your tax liability beyond zero so that a refund become possible.
Common Refundable tax Credits
The Child Tax Credit
The Credit for Other Dependents
Child and Dependent Care Credit
Earned Income Tax Credit (EITC)
The Retirement Savings Contributions Credit (The Saver's Credit)
The American Opportunity Tax Credit (AOTC)
The Federal Adoption Tax Credit
Plug-In Electric Vehicle Credit
Below the line deductions
We mentioned above the line deductions, but there are also below the line deductions. So how do they work? Lets just say you have a Schedule A you have listing your personal deductions like medical expenses and taxes paid. Now Schedule A deductions comes in below the line. What this means it is can really get beat up if your income is too high. Below the line deductions are subject to the most restrictions - meaning it is like you didn’t have the deduction at all. This happens most often because the people writing the tax code felt you made too much money this year. Progressive taxation is ugly all around - tax rates go up, and too, the value of deductions and credits can go down or even approach zero.
Tax credits are generally better than deductions but not always. Refundable tax credits are usually better than nonrefundable tax credits. Tax deductions usually aren’t as powerful, but we at least know that above the line deductions are usually better than below the line deductions as there are fewer restrictions.