What is the difference between a tax deduction and a tax credit, examples and which is better?
Tax credits and deductions can be worth thousands of dollars to filers though one of them has a significant advantage over the other.
Tax season is now underway with filers having nearly three months to send their tax returns to the IRS. They can save thousands of dollars by taking advantage of the various deductions and tax credits that are available to filers. They are sometimes referred to interchangeably, but deductions and credits are completely different.
What are tax deductions?
Deductions allow filers to reduce their eligible income before calculating the tax liability. Reducing the amount of qualifying income helps to reduce how much tax you are required to pay.
Out-of-pocket expenses for charity work can be claimed as a tax deductible, saving the cost of cupcake ingredients for example.
What are the standard deduction thresholds?
The standard deduction threshold is the amount of your total income that is not subject to tax. This first ‘tax-free’ portion of your income is subtracted from your total income to calculate the amount of earnings that is subject to tax.
Each year, to keep up with inflation, the IRS issues an adjustment to the standard deduction thresholds:
- Single - $14,600
- Head of Household - $21,900
- Married and Filing Jointly - $29,200
Unlike other forms of deductions, the standard deduction does not need to be justified with any supporting documentation. You simply cite it in your tax return and wipe off the relevant amount from your liable income.
What are tax credits?
In contrast, credits are solely used to reduce your eventual tax liability. Once your tax balance has been calculated credits subtract a set dollar amount from your outstanding balance, which reduces your bill or increases your refund.
One of the most notable examples relates to electric cars. The tax credit can claim back thousands of dollars if people purchase a new plug-in electric vehicle (EV) or fuel cell vehicle (FCV) from 2023 onwards. The credit can be worth up to $7,500.
Which is better?
Tax credits are regarded to be better than deductions as credits reduce your tax by dollars compared to deductions minimising tax you already have to pay.
Credits that are larger than the tax you pay also means a tax refund once your tax filing has been processed.