What Are The Differences Between Tax Deductions And Tax Credits?

Differences between tax deductions and tax credits

We all like to claim tax deductions and credits when filing our tax returns. They both allow us to pay less tax—and who doesn’t like that? 

But do you know that tax deductions and tax credits lower our taxes using totally different mechanisms? In other words, they are not the same thing and many people often don’t realize this. 

So, how can you tell these two confusing concepts apart? 

Read on to find out! 

What is a tax deduction?

A deduction lowers the income subject to taxation, resulting in you paying less in taxes. In other words, before calculating how much tax you owe, you subtract deductions from your income. Common tax deductions include home office deduction, student loan interest, and retirement contributions.  

How much you can save from tax deductions depends on your marginal tax rate. Simply multiply the tax deduction by the marginal tax rate to figure out how much that deduction can decrease your taxes. For example, if you have a $2000 deduction and you fall into the 22% tax bracket, you will be able to lower your taxes by $440. So, the higher the tax bracket you’re in, the more value deductions will bring to you. 

What is a tax credit? 

A tax credit lowers the amount of taxes you owe directly. Common tax credits include the American Opportunity Tax Credit (AOTC), the Child Tax Credit, and the Saver’s Tax Credit

It’s very simple to know how much your tax credit will save you. You don’t need any marginal tax rate or calculation. Once you meet all the requirements of a specific tax credit, subtract the value of that tax credit directly from your taxes. 

For example, let’s say you have a tax bill worth $6000 this year. A $2,000 tax credit decreases your taxes straight down dollar for dollar—now you only owe $4000 to the IRS! 

Tax deduction vs. Tax credit: Which one should you choose? 

Generally, tax credits benefit you more than tax deductions since they lower your tax bill directly. Still, if you can only take a tax credit or a deduction for the same expenses, do the math to determine which one will save you the most money possible. 

In conclusion 

Knowing how to distinguish between these two important tax terms, tax deductions and tax credits will help you file taxes quicker and more accurately and prevent you from making unfortunate costly mistakes. 

After you file your tax return, you may think the tax nightmare is over. However, to be cautious, experts advise keeping a copy of tax receipts for up to seven years in the event of audits. If you need an easy way to deal with this, Shoeboxed can help you! 

Shoeboxed is an online application that can transform your receipts and documents into digital in just a click. Then, it automatically extracts, categorizes, and human-verifies important data from your receipts so that you can go over and check your records anytime with ease. Shoeboxed ensures you will always have your receipts securely stored and ready for tax purposes. 
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