Tax Credits and Deductions are the most often asked question and probably the most beneficial part of preparing your tax return. They both help you save money by reducing your overall income tax liability. So, you should take advantage of all the tax credits and deductions you can. If you have any questions about tax credits and tax deductions. Always ask your tax professional for an explanation.
As many people still get confused about the difference between tax credits and tax deductions, here’s a simple introduction to these two in the light of the New Tax Reform Act that has just been approved by the US Congress.
The difference between the tax credits and the tax deductions is the way they lower your tax liability:
Tax credits reduce your tax bill dollar-for-dollar, which means that a $500 tax credit will lower your tax bill by $500.
Tax credits always result in higher reductions of your tax liability, and sometimes they can reduce your tax owed to zero. If you have a tax liability of $600 and you apply for a $1,000 tax credit, you won’t have to pay any tax, but the remaining $400 of the tax credit WILL NOT be refunded. This is normally the case, as the majority of any excess tax credit is not refundable.
The child tax credit is one of the very few refundable tax credits. Even if your tax liability is zero, you can still claim the child tax credit and the IRS will send you a check for the unused overage.
The IRS offers a wide array of tax credits, however, they do not apply to everyone. You need to know what type of credits are available in your particular situation. Depending on your filing status, age, employment, etc. various limitations might apply.
You need to also be aware of how certain tax credits, deductions and exemptions correlate with each other, as you might find that claiming one, might disallow you from claiming another. That might be the reason over 70% of taxpayers seek professional assistance with their taxers. Even the IRS advises consulting a tax professional if you’re unsure about the credits and deductions you are planning to claim. Tax credits are generally less common and less known than tax deductions.
Tax deductions lower your taxable income. (Taxable income is the base you will use to calculate the percentage of your tax liability). Therefore, the lower your taxable income, the lower your tax liability will be. Based upon your tax bracket and your taxable income the tax percentage due will be calculated.
Tax deductions lower your taxable income and there are two main types of deductions: the standard deduction and itemized deductions. Most of the taxpayers choose the standard deduction, however, if your itemized deductions are greater than the standard deduction, you should always use the itemized deductions option.
While the standard deduction is fixed and depends upon your filing status, the itemized deduction allows claiming a greater deduction. (Given that the total amount of your qualified deductible expenses are higher than the standard allowable deduction). Itemized deductions may be subject to various limitations (depending upon the type of expenses), as some of them are based upon a minimum amount, and you can only deduct the expenses that exceed this amount.
2018 Changes Most of the new changes starting in 2018 to the tax code (under the new bill), won’t take effect until January 1, 2018. (Meaning they will only apply to the return you will file in 2019. One of the biggest changes will affect your itemized medical deductions during 2018. The minimum amount of 10% of your adjusted gross income dropped to 7.5%, which means you can deduct more of your medical expenses starting in 2018.
To itemize your deductions, you need to complete form Schedule A. You can only file the Schedule A with 1040 (1040A and 1040EZ disallow itemized deductions). It is also important that you keep all records of those itemized deductions for at least three (3) years, in case the IRS asks for them.
What is better? Credit or Deduction?
Tax credit and tax deductions are different and vary depending on your situation. There’s no better or worse for that matter. Both offer various benefits if you qualify. Note, that you need to qualify for the credits or deductions before claiming them on your tax return. Misinformation might trigger IRS audit and there is a potential risk of penalties, thus make sure you know what you’re claiming. Consult a professional if necessary.