It’s shocking how much your tax bill can change ($$$) if you mistake a tax deduction for a tax credit (or vice versa). First, let me tell you: they’re two different things. Second, their effect is not similar; one reduces your taxable income, while the other reduces your tax bill by the amount of the credit.
Let’s go back to the beginning of tax law (not how it used to be, but how it is today) because most of us never ask about the actual effect of any type of tax deduction/credit.
For example, most people see the word “deduction” and assume they got a good deal, but they don’t really understand what the deduction means to their final tax liability. Use “credit” and many people are likely to think it’s a tax term (not true). These two different tax categories are completely different.
The IRS clearly knows the difference between a tax deduction and a tax credit, so be sure you do, too!
Tax Credits = Big (Unexpected!) Savings
When you receive a tax credit, you are getting a dollar-for-dollar deduction from your tax return. For example, if your tax bill is $10,000, and you’re eligible for a $5,000 (or more!) tax credit, your new tax bill will be $5,000. How do I know? No fuzzy math and absolutely no fine print tricks.
There are two distinct types of credits.
- Non-Refundable Credits Reduce Your Tax Bill But Do NOT Refund You For Any Remaining Amount.
- Refundable Credits Will Refund You Whether They Exceed Your Tax Bill Or Not.
This means that if the amount of the credit you receive exceeds the amount of taxes you owe to the government, then you will receive an actual check in the mail from the IRS.
This is where many people become confused. Often, deductions and credits are discussed together, included in the same sections of various tax websites and explained with examples that have been written almost the same way. However, these are completely different things.
Now let’s go on to discuss deductions.
Tax Deductions: The Not So Obvious Helper
A tax deduction does not actually lower your tax bill; it lowers the amount of income that is used to calculate your tax bill.
Example time, because it can be very confusing very quickly!
If you earn $50k per year and your tax rate is 20%. Without taking any deductions, your tax bill is $10,000.
Now assume you qualify for a $5k deduction. Your taxable income has now decreased to $45,000 instead of $50,000. So you multiply your taxable income ($45k) times your tax rate (20%)…and your tax bill is now $9,000. That $5k deduction saved you $1,000 in taxes; not $5,000.
Is that a good thing? Yes. But it is not nearly as good as a credit.
A Lot of People Take the Standard Deduction Instead of Itemizing Their Deductions
In the U.S., many of us take the standard deduction because it’s typically higher than most people will find itemizing their deductions. And it also makes it a lot easier for everyone to file their taxes.
When you take the credit most of your deductions will be gone… there are a few that surprise people every year at tax time.
To re-illustrate the previous example, but instead of deductions, you have a credit:
Example: You are still making $50,000 and have $10,000 in taxes owed, but now you have a $5,000 tax credit.
Now, take $5,000 off your $10,000 tax bill and you have a new bill of $5,000.
Identical value but different result.
Refundable vs. Non-Refundable: Here Comes The Twist
Let’s say you have a $10,000 tax liability, and you qualify for a $12,000 credit:
- Refundable Credit = Your tax bill is $0, and the IRS will send you a check for $2,000.
- Non-Refundable Credit = Your tax bill is $0, but the $2,000 credit disappears like a puff of smoke.
The same dollar amount of credit can cause radically different outcomes, depending on how and where you spend it.
The IRS publishes both complete lists of allowable deductions and complete lists of allowable credits. Not knowing about all the items available to you could potentially leave a hole in your pocketbook, as some are easily inferred while others are more obscure or require some research to identify.
If your tax refund is lower than you expected, it’s possible you may have overlooked a valuable tax deduction.
Tax refunds tend to be polite in their nature. Tax rebates usually display a more aggressive perspective.
Both refund types provide value; however, one form definitely carries a greater financial impact. It’s not simply helpful information…knowing the difference will save you money every year if you utilize it.
So the next time you hear a comment implying that tax deductions and tax rebates are virtually identical, keep in mind that this statement is incorrect.
