Everyone wants to lower their tax bill come tax season. One of the most effective methods to lower tax bills is through a tax deduction or a tax credit. Although both methods can save money, knowing their differences can help maximize savings.
How a Tax Deduction Works
Using a tax deduction reduces your taxable income. This indirectly lowers your tax bill. There are savings in each tax bracket, so the total savings will differ and directly relate to the tax bracket.
A tax deduction example is often seen in a person who holds a 22% tax bracket. That individual will save $220 if they claim a $1000 deduction. This is because certain brackets will have better savings.
In short, a person with a higher tax rate and income will save more with tax deductions. Common deductions often seen in the market that can help save money are paying interest on mortgage, student’s loan, and even charitable contributions.
How a Tax Credit Works
A tax credit is a rebate or payment that the IRS gives to a taxpayer to lower the tax claim and check off the taxes they owe. Unlike deductions lower taxable income, a tax credit will lower the bill directly, regardless of income.
In the deduction example, with the same tax and credit limit of 2000, having a credit worth half the payment would lower the tax bill to 1000.
Credits can either be refundable (you receive a refund even if your tax balance is zero) or non-refundable (they only reduce tax liability to zero). Examples of refundable credits are the Child Tax Credit or Earned Income Tax Credit. Education credits are also refundable.
Which Is More Valuable?
As a general rule, tax credits are of greater value than deductions of an equivalent amount. For example:
- Under a 22% tax rate, a $1,000 deduction saves $220.
- With a tax credit, the entire $1,000 is saved.
Credits are more advantageous than deductions because they reduce the tax bill.
The Bottom Line
In almost every situation, tax credits will yield more savings than deductions of the same amount. That said, both credits and deductions serve an important purpose in tax strategy. While deductions may stack up significantly for an itemizer, credits always yield savings.
You can maximize your tax savings with professional assistance. Reach out to Dimov NYC CPA today to get custom-personalized advice on deductions and credits.
