Have you ever wondered the difference between tax credits and tax deductions? Or how tax deductions and tax credits can save a significant amount each year in taxes? This article will explore tax deductions and tax credits, the differences and benefits, common deductions and credits, and potential tax planning strategies.
What is a Tax Deduction?
A tax deduction is a reduction of income before taxes are calculated. For example, if you have a capital loss from stock sales of $1,000 and income of $100,000, your taxable income will be $99,000, resulting in less tax liability (the amount of taxes you owe). It is essential to understand that a tax deduction is applied before your taxes are calculated, so it may be less beneficial than a tax credit, depending on your tax bracket, which we will explore further below.
Deductions are not always shown on the first couple of pages of your tax return when calculating your taxes. Most individuals who are W2 employees will see a reduction in taxable income from health plans, pre-tax retirement plan contributions, and some other benefits through your employer. This is all shown on your W2. Box 1 will show your taxable income (after deductions are taken out), box 5 will show your Medicare wages (this is your gross income before deductions are removed), and boxes 12a-12d will show those deductions removed along with other supplemental information. Commonly, these are your pre-tax 401(k) contributions, health care premium payments, and commuter benefits. This is why you are not often taxed on your total gross income through your job and why it is reduced on line 1 of your tax return.
Common Tax Deductions
In addition to your W2, you will find some of the more common deductions on your Schedule A or itemized deductions. Most taxpayers will likely take the standard deduction due to the increase made after the 2017 Tax Cuts and Jobs Act (TCJA). The standard deduction increases year-to-year by inflation but currently stands at $14,600 and $29,200, depending on your filing status (single or joint). Schedule A allows you to deduct medical expenses (above 7.5% of your AGI), state and local income or sales tax, state and local real estate taxes, property taxes, mortgage interest, points, charitable gifts, and casualty and theft losses. For example, if you own a car or a home, you can deduct your yearly real estate taxes, personal property taxes (car tabs), state and local income or sales (if you live in a no-income-tax state like Washington) taxes. The largest, however, will likely be your mortgage interest. In the early years of your mortgage, the majority of your mortgage payments go towards the mortgage interest, so this is commonly larger in the earlier years and decreases over time. When itemizing your expenses there are a few rules to remember. First, you are capped at $10k for your state and local taxes (lines 5-6). Second, you are limited to deducting interest on your mortgage up to $750k in indebtedness ($1m if the home was purchased before the 2017 TCJA). Lastly, charitable gifts are also limited, but this is hard to hit unless you are gifting more than 50% of your adjusted gross income (AGI). If the summation of those itemized deductions is above the standard deduction, it’s more beneficial to itemize. Otherwise, you will use the standard deduction.
Less Common Tax Deductions
Other uncommon deductions not on your W2 or Schedule A are listed in Part II of your Schedule 1. Schedule 1 is an extension of your tax return that shows additions and deductions from your income. Some deductions include educator expenses, the deductible portion of self-employment tax, and the student loan interest deduction. Remember that deductions are not always obtainable, and many come with phaseouts or thresholds of income that, if you exceed them, will disallow you from utilizing the deduction. For example, you cannot take the student loan interest deduction if your income (modified adjusted gross income) is above $95k if you are filing a single return or $195k if you are filing a joint return. It is important to understand how tax deductions apply to your tax return and which ones you might qualify for, as they are a great way to reduce your tax liability in any given year.
What is a Tax Credit?
Tax credits have two main similarities to tax deductions: they can reduce your tax liability, and some credits also have phaseouts and thresholds based on income. The key difference and the definition of a tax credit is that it is a dollar-for-dollar reduction of your overall tax liability (taxes owed). For example, if your tax return shows that you have $12,000 in taxes calculated after all income and deductions have been added/subtracted, a $2,000 tax credit would reduce your overall tax liability to $10,000. As mentioned, you will run into phaseouts based on income for most tax credits. For example, the child tax credit starts to phase out at $200k if you are a single filer and $400k if you file jointly. Much like tax deductions, there are many tax credits that the government and IRS add and remove from your tax returns every few years as incentives to taxpayers. For example, the child tax credit is to incentivize family growth and help offset the cost of having children (albeit at $2,000 in 2024). Now that we have reviewed the basics of tax deductions and tax credits, it is time to review how they work together and how to compare them.
Common Tax Credits
Tax credits are less common, but it does not mean you will be thwarted from utilizing them. The most common tax credits will be for those who have children and are in school. The child tax credit is a $2,000 credit per child credit if you are under the phaseouts to receive the credit. These phaseouts start at $200k for a single filer and $400k for a joint filer. In addition, the child and dependent care credit allows you to take credit for expenses paid for childcare for children under 13 and for a spouse or parent who cannot take care of themselves. This credit is limited to 20%-35% (depending on your income) of the first $3k of expenses or $6k if paid for more than one individual. Remember that you cannot claim the same expenses from a dependent care flexible spending account. The American Opportunity tax and Lifetime Learning credit are also great tools if you are in school.
The Differences Between Tax Deductions and Tax Credits
As mentioned, tax deductions reduce your income before your tax liability is calculated, and a tax credit reduces your overall tax liability after it has been calculated. In most cases, either a deduction or a credit will benefit you. However, tax deductions will benefit those in higher tax brackets more. For example, if you take someone in the 24% tax bracket and someone in the 35% tax bracket who has a similar $5,000 deduction, then the equivalent tax credit on that would be $1,200 ($5,000*.24) for the 24% taxpayer and $1,750 ($5,000*0.35) for the 35% taxpayer. Since the 35% taxpayer is paying more taxes on their income, a deduction will go further for them. The opposite is true for tax credits, as those will benefit a lower tax bracket more. For example, if we have the same taxpayers in the 24% and 35% brackets and each has a credit of $1,000, then the tax deduction equivalent will be $4,167 ($1,000/0.24) for the 24% taxpayer and $2,857 ($1,000/0.35) for the 35% taxpayer. It is important to understand this point because you cannot, in some cases, take a deduction and a credit on the same item or expense. Most commonly, you see this with the dependent care credit. The dependent care credit allows taxpayers to take a credit for a portion of the expenses paid for childcare. However, if they also have a dependent care flexible spending account (DCFSA), which allows for pre-tax deductions via payroll (something that would be shown on your W2), then you cannot take the dependent care credit on the expenses paid from the dependent care FSA. In most cases, you will have enough expenses to cover both, but the key distinction is that you cannot include the expenses paid out of the DCFSA in calculating the dependent care tax credit. A lot of tax deductions and tax credits share similarities. Be sure to understand which deductions and credits you are taking to ensure you are not inadvertently double-dipping.
Tax Planning Strategies Using Tax Deductions and Tax Credits
When considering different tax credits and deductions to reduce your overall taxes, it is first important to understand your current situation. For example, knowing roughly how much income you will have, understanding your marginal tax rate (the highest income tax rate you will pay), and any changes you may have throughout the year will help you determine which strategies to deploy.
The easiest way to limit your tax liability is through employee benefits. If you have a 401(k), health insurance, and other pre-tax benefits, maximizing those will help limit your taxable income and, thus, your tax liability. This is important as some deductions, especially credits, have phaseouts. For example, if you are a single parent making $210,000 annually and contribute $15,000 to your pre-tax 401(k), you will reduce your taxable income below the $200,000 threshold to obtain the child tax credit. This is another reason why it is important to understand your current income and marginal tax rate.
A significant strategy resulting from the TCJA of 2017 is lumping charitable contributions for two years into one. The new tax reforms resulted in a substantial increase in the use of the standard deduction as it was essentially doubled from previous years, leading to less use of itemized deductions and Schedule A. However, an interesting strategy developed out of those reforms. If, for example, you are a taxpayer who regularly donates to charity, but the increased standard deduction did not allow you to itemize, your charitable contributions would result in no tax benefit. So, the strategy is to “lump” two years’ worth of contributions and make those in one tax year, and plan to take the standard deduction in the following year with no charitable contributions. This would allow the taxpayer to take more than the standard deduction by itemizing (only if larger than the standard deduction) in every other tax year instead of continuing with the same contributions year-over-year and seeing no tax result. For example, if a taxpayer regularly contributes $2,000/year to charity and the rest of their itemized deductions equate to $12,000, then they would use the standard deduction of $14,600 as it would result in a larger deduction. This would continue every year with no tax benefit to their charitable contributions. Instead, if they skipped one year, and made a $4,000 contribution in the following year with a total of $16,000 in itemized deductions, then they would itemize and see a tax benefit to their charitable donations. Remember that the standard deduction increases yearly, so be sure you know where the threshold is.
The Bottom Line
There is an abundance of tax credits and tax deductions, which can reduce your overall taxes paid in any given year. It is helpful to understand how these work, how they apply to your taxes, and what changes in your life may create or remove a deduction or credit. This will help you stay unsurprised by a large tax bill or refund. Taxes are a complex box to unwrap, but I hope this article gives you more insight into how your taxes are done. For more questions and tax insights, schedule a free consultation today!
