Tax credits vs tax deductions: what’s the difference?
There’s a lot to be confused about when filing your taxes, especially when it comes to tax credits vs. tax deductions. The two are very different and it’s important to understand how each can work for you when it comes time to file your taxes.
Tax credits
Tax credits can reduce the amount of tax you owe or increase your tax refund. For example, if you get a tax credit of $500, your tax bill will be reduced by $500. Some tax credits can result in a refund check; however, this does not apply to all tax credits. Refer to the IRS website to find more information on which tax credits are refundable. There are tax credits for education, investing in retirement, energy-efficient homes, clean vehicles, for middle- to low-income households, and more.
Tax deductions
On the other hand, tax deductions can reduce the amount of your taxable income before you calculate the tax you owe. Taxable income is the amount of your income that will be subject to taxes. You start by subtracting “above-the-line” deductions from your gross income to get your adjusted gross income (AGI).
Above-the-line deductions might include alimony payments (if divorce agreement was executed before 2019), student loan interest, military moving expenses, and more. (For the IRS’s full list of expenses you can deduct whether you claim the standard deduction or itemize, see here.)
After you have your AGI, you can either take the standard deduction or itemize deductions on Schedule A of Form 1040. Common itemized deductions include the mortgage interest deduction, the state and local tax deduction, and the charitable contributions deduction. The final amount will be multiplied by your tax rate to calculate your tax bill, according to your tax brackets.
How to use tax credits and tax deductions together
To show an example of how a tax credit would differ from a tax deduction, let’s review the numbers for Sally Jones. Sally is a single mother with two children. She works in tech, with a gross income of $150,000 per year. She is not covered by a retirement plan at work, so she contributed $6,500 to an IRA. She can take this as an above-the-line deduction.
Her itemized deductions for her charitable donations, state and local income tax, and mortgage interest, add up to $20,000. She gets a $2,000 tax credit for each of her two dependent children along with a $7,500 tax credit for buying a Tesla Model 3 earlier this year.
All in all, Sally has total deductions of $26,500 and a tax credit of $11,500:
| Gross Income | $155,000 |
| Above-the-line Deduction | -$6,500 |
| AGI | $148,500 |
| Itemized Deductions | -$20,000 |
| Taxable income | $128,500 |
| Effective Tax Rate* | 19% |
| Tax rate x taxable income | $24,415 |
| Tax credit | -$11,500 |
| Tax Bill | $12,915 |
*Effective tax rate is the average rate a taxpayer will owe on earned income. This is just an example rate and may not be indicative of what someone in this tax bracket would owe.
This article is for educational purposes only and should not be taken as tax advice. Speak to a licensed tax professional for tax advice.
Disclosures:
All examples above are hypothetical, do not reflect any specific investments, are for informational purposes only, and should not be considered an offer to buy or sell any products. M1 does not provide any financial advice.
All investing involves risk, including the risk of losing the money you invest. Brokerage products and services are offered by M1 Finance LLC, Member FINRA / SIPC, and a wholly owned subsidiary of M1 Holdings, Inc.
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