By When preparing your taxes, understanding how credits and deductions work could put hundreds – or even thousands – back in your pocket. While both reduce your tax bill, they operate quite differently in terms of their impact.
How Tax Deductions Work
Deductions lower your taxable income before calculating what you owe. Think of them as discounts on the income that gets taxed.
Key Features:
- Reduces the amount of income subject to taxation
- Value depends on your tax bracket
- Comes in two forms: standard or itemized
Example:
If you earned $60,000 and qualify for a $12,950 standard deduction (2022 single filer amount), only $47,050 gets taxed. For someone in the 22% bracket, this saves $2,849 in taxes.
How Tax Credits Work
Credits provide direct dollar-for-dollar reductions of your tax bill after calculating what you owe. These are essentially refunds on your tax liability.
Key Features:
- Directly reduces your tax bill
- Often more valuable than deductions
- Some are refundable (you get money back even if credit exceeds taxes owed)
Example:
The Earned Income Tax Credit could give a qualifying family $6,935 directly off their tax bill – or as a refund if it exceeds what they owe.
Which Packs More Punch?
Credits typically offer greater savings:
$1,000 Deduction vs. $1,000 Credit
- For 24% bracket: $240 savings vs. $1,000 savings
- For 12% bracket: $120 savings vs. $1,000 savings
However, deductions still matter because:
- They can push you into a lower tax bracket
- Certain deductions have no income limits
- Some expenses qualify for both (like education costs)
Smart Strategy for Maximum Savings
- Claim all eligible deductions first to lower taxable income
- Apply available credits to slash your tax bill
- Look for opportunities that offer both (retirement contributions may qualify)
The most effective tax plans utilize both tools strategically. Work with a tax professional to identify which combination works best for your unique financial situation – the savings are often greater than people realize.
Remember, tax laws change annually, so reviewing available deductions and credits each year ensures you don’t leave money on the table. A few hours of planning could yield significant financial benefits.