Tax season is here, and with it, a flurry of articles on current tax rates, tax filing guides, and tax minimization strategies. One common way to lower taxes is through tax deductions and tax credits. However, the mechanics of how they work differ.
Tax Deductions
A tax deduction reduces a person’s taxable income. There are two types of deductions: standard and itemized. A standard deduction is a fixed amount each taxpayer can deduct to determine their taxable income. The Internal Revenue Service (IRS) provides the standard deduction amounts each year, and they are available for most taxpayers. For the 2023 tax year, the standard deduction for Single and Married Filing Separate tax filers is $13,850,$27,700 for Married Filing Jointly & Surviving Spouses tax filers, and $20,800 for taxpayers filing as Head of Household. In addition to these figures, individuals who are blind or over the age of 65 are allowed additional standard deductions.
An itemized deduction is an allowable reduction in taxable income based on specific expenses. A tax filer could utilize several types of itemized deductions in a given tax year. Common examples of itemized deductions are charitable gifts, state income taxes, and medical expenses. However, itemized expenses have specific qualifications that must be met to be utilized. For example, if a person wishes to itemize their medical expenses, they could only consider medical and dental expenses paid for themselves, their spouses, or dependents not reimbursed or compensated by incomes that exceed 7.5% of their adjusted gross income.
A taxpayer will either use their standard deduction or itemized deduction based on which value is larger and thereby would result in lower taxable income. Due to the increased standard deduction amount after the passing of the Tax Cuts and Jobs Act (TCJA) of 2017, most tax filers utilize the standard deduction rather than itemized deductions.
Tax Credits
A tax credit reduces the amount of actual taxes owed. Stated differently, the total amount of a tax credit will reduce the amount that a taxpayer owes by precisely that amount. This differs from a tax deduction, which reduces taxable income before calculating the amount of tax that the filer owes. Common tax credits are the child tax credit, child and dependent care credit, American Opportunity Tax Credit, and Lifetime Learning Credit.
Tax credits like tax deductions have specific qualifications that a person must meet to be eligible to claim on their tax return. For example, to be eligible to claim the American Opportunity Tax Credit, there is a modified adjusted income limit of $180,000 for joint filers and $90,000 for single filers. The claimant must have spent money on qualified expenses like tuition, enrollment fees, or materials required for study for students pursuing an undergraduate degree or other recognized educational credential at least part-time. Students also must not have a felony drug conviction. This credit can be claimed by the tax filer, their spouse, or a student that the tax filer claims as a dependent. The maximum credit a person can claim is $2,500 and only for four years per student.
Which is better?
Mathematically, a tax credit will lower a tax bill more than a tax deduction of the same value because it reduces a filer’s tax liability dollar-for-dollar rather than just lowering their taxable income. However, the answer to whether a tax deduction or a tax credit is better for a specific taxpayer is “it depends.” Much of what determines if a tax deduction or tax credit is more beneficial to an individual taxpayer or household depends on what they personally can qualify for, which, as this article highlights, can significantly narrow the options available.
