Most Taxpayers Don’t Understand How Tax Credits Actually Work

Tax credits and tax deductions both help you save money on your IRS bills, but they are not the same.  Unfortunately, research from the Tax Foundation revealed that 64% of survey respondents didn’t know whether a credit or deduction provided more value when filing. This lack of knowledge can lead to mistakes and missed opportunities when filing taxes.

To help you avoid confusion, here’s what you need to know about both credits and deductions and how they help you save on your taxes.

What is the difference between a tax credit and a tax deduction?  

Although a tax credit and a tax deduction both save you money, they do it in different ways. 

A tax credit provides a dollar-for-dollar reduction off your total tax bill. Let’s say you are a parent who qualifies for the Child Tax Credit, which is worth $2,000 per qualifying child. If you owe $8,000 to the IRS, you would be able to subtract $2,000 from that $8,000. This would mean that you would only owe $6,000 instead of $8,000. 

A tax deduction doesn’t provide as much savings, although it still helps you to reduce your bill.  It does that by allowing you to reduce the income you are taxed on. Let’s say, for example, that you qualified for a $2,000 deduction. You would not subtract $2,000 from your tax bill this time. You’d subtract $2,000 from your income before your taxes are calculated.

If your household income was $50,000 and you qualified for a $2,000 deduction, you would not be taxed on $50,000 anymore. You would subtract $2,000 from $50,000 so you would only pay taxes on $48K. If you were a married joint filer, you’d be in the 12% tax bracket based on your income. So, by avoiding paying taxes on $2,000, you’d save 12% of $2,000. The deduction would save you $240 off your taxes.

That’s obviously a lot less savings than the credit provided. Still, getting any amount off can be helpful. 

Some tax credits are refundable

Tax credits also have another unique feature. They are sometimes refundable. This means it may actually be possible to get more back from the IRS than you paid in. For example, a portion of the child tax credit called the Additional Child Tax Credit, is refundable. This credit is worth $1,700 per child. 

If you qualify for the refundable credit and you owe only $500 in taxes, you would still get to subtract $1,700 from the $500. That would mean the IRS actually pays you $1,200 when you file your tax returns. 

With the ability to bring your tax bill to below $0, it’s easy to see why you absolutely do not want to miss any credits. 

You should get help with your taxes

As you can see, there’s a lot to know when it comes to taxes. This is also just the beginning of the information you need. For example, you may have to choose between claiming something called the standard deduction which is a set amount of money anyone can subtract from their taxable income, or itemizing and claiming deductions for specific things. 

Very few people who aren’t financial experts truly understand the ins and outs of the tax code, so it’s a good idea to get professional help from a financial advisor when you are preparing your taxes. This way, you can save as much as possible and keep more of your hard-earned money in your own pocket.