The process can be confusing no matter how you prepare your tax returns. You intuitively understand that a certain percentage of your income will be taxed. But your annual salary or wages are never the same as your taxable income. And then there is the magic number of taxes owed. To arrive at that number, there is a formula that involves two of the most common tax terms, deductions, and credits. So, what are they? And how are they different?
Short answer: Tax deductions lower your taxable income and potentially reduce what you’ll pay in taxes, while tax credits reduce your tax bill dollar for dollar and may even increase your refund. Therefore, credits are better at reducing the taxes you owe and sometimes result in a refund.
Tax credits directly reduce the amount of taxes you owe, providing you with a dollar-for-dollar reduction. For example, if you qualify for a $3,000 tax credit, you'll save $3,000 on your tax bill. In some cases, a tax credit can lower your tax bill and result in a tax refund. For example, if you qualify for a fully refundable tax credit of $1,000 and you owe only $700 in taxes, you'd receive a tax refund for the $300 credit in excess of your tax bill.
A tax deduction lowers your taxable income and, in turn, lowers your tax bill. Unlike a tax credit, a deduction won't lower your tax bill dollar for dollar. Instead, the amount a deduction reduces your tax liability depends on your income tax bracket. Your income tax bracket determines the tax rate you pay on various chunks of your income. Since the marginal tax system increases tax rates as income rises, deductions can result in higher dollar amount of savings for those with higher incomes.
Tax credits and tax deductions are two ways to reduce your tax bill. Understanding how credits and deductions work and how they differ can help you save more money. Hopefully, that next inevitable tax return will be a little less confusing.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice. Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.