Tax credits and tax deductions can both reduce what you owe in taxes each year, but they work differently.
Deductions can reduce the amount of income you have to pay taxes on, which can lower your final bill. Tax credits are a dollar-for-dollar reduction in what you owe — and might even get you a bigger tax refund.
It’s possible to qualify for tax credits and tax deductions, but it’s important to know how both options work.
What Are Tax Credits?
Tax credits represent a dollar-for-dollar reduction in your overall tax burden. They directly lower the tax amount you owe to Uncle Sam.
For example, if you owe $1,500 in taxes but qualify for a $500 tax credit, your total tax bill will decrease by $500, meaning you’ll only have to pay $1,000.
Feeling Lost? Check out SoFi’s Tax Season Help Center.
How Do Tax Credits Work?
When filing your taxes, you can use IRS resources, tax software, or a certified accountant to research tax credits for which you may be eligible. If it’s your first time filing taxes, these resources can be especially helpful.
Even if you don’t owe anything in taxes, it’s worth looking into tax credits. Why? Because some tax credits are refundable, meaning the government might owe you money:
• Refundable tax credits allow your tax liability to go below zero. For example, if you owe $100 in taxes but receive a $500 refundable tax credit, the government will actually owe you $400.
• Nonrefundable tax credits do not work that way, unfortunately. If you qualify for a non-refundable tax credit, the best it can do is eliminate your tax liability (meaning you owe nothing). But even if the credit is large enough to wipe out what you owe and there’s still money left over, you don’t get to pocket that extra money.
Tax credits are not for everyone. Each credit has specific requirements to qualify.
And if you’re wondering what happens if you miss the tax deadline, tax credits would still apply for the year that you’re filing your taxes.
Common Tax Credits
Your tax software or accountant should know the full list of tax credits to look out for, and the IRS website features the whole list. Before diving into your taxes, however, it’s a good idea to note some of the most common tax credits for which you may qualify:
• Earned Income Tax Credit: Commonly called by its initials (EITC), this refundable tax credit is for low- to moderate-income workers. The amount you might qualify for and your eligibility can vary depending on whether you have dependents and/or have a disability.
• American Opportunity Tax Credit: This education tax credit is partially refundable. Students (or parents claiming a student as a dependent) can claim this tax credit for the first four years of higher education. It’s $2,500 per eligible student, but once your tax bill hits zero, you can earn 40% of whatever remains (up to $1,000) as a tax refund.
• Child Tax Credit: Even if a child isn’t enrolled in higher education, parents have access to a handy tax credit. The Child Tax Credit is a refundable tax credit for parents (with dependent children) who meet income requirements.
• Child and Dependent Care Credit: Parents have access to yet another potential tax credit, this time for those who pay for babysitters or daycare. The credit amount depends on your income, child care costs, and number of children requiring care. Prior to the 2021 tax year (filed in 2022), this was nonrefundable, but the American Rescue Plan Act made it refundable.
You can use tools on the IRS website to discover if you qualify for these and other tax credits.
Recommended: Do I Need a Personal Accountant?
What Are Tax Deductions?
Tax deductions are another way to reduce your tax burden, but they work differently. While a tax credit discounts your final tax bill after all the calculations, a tax deduction reduces the amount of income eligible for taxes.
The more deductions you have, the less money you have to pay taxes on. This can result in a lower overall tax bill, but it cannot result in a tax refund.
Recommended: What Triggers an IRS Audit?
How Do Tax Deductions Work?
Let’s look at an example to understand how tax deductions reduce what you owe:
If you made $100,000 in a given year, you would owe 24% in federal taxes based on your marginal tax bracket, or $24,000. But if you have $10,000 in tax deductions, you instead only owe 24% of $90,000, which is $21,600.
In this example, your total tax deductions equal $10,000 — but they reduce what you owe by just $2,400.
In calculating how much a tax deduction will save you, it’s important to know which tax bracket you’re in — your tax bracket represents the percentage at which your income will be taxed. In general, the more money you make, the higher the tax rate.
Common Tax Deductions
Nearly every tax filer is eligible for the standard deduction. Without inputting any information accounting for business expenses, medical costs, charitable contributions, student loan interest payments, and other eligible deductions, you can simply subtract the standard deduction amount from your taxable income.
For the 2022 tax year (which will be filed in April of 2023), the standard deduction is:
• $12,950 for single taxpayers (and married, filing separately)
• $25,900 for married taxpayers filing jointly
• $19,400 for heads of household
Many people choose to take the standard deduction, but if you qualify for various deductions that would amount to more than the standard deduction, it’s worth itemizing your deductions.
An accountant or tax preparation software may be your best bet for determining which deductions you qualify for. Here are some of the most common types of deductions:
• State and local taxes
• Business expenses (if you are self-employed)
• Mortgage interest
• Property taxes
• Qualifying medical expenses
• Charitable contributions
• Student loan interest
• Gambling losses
You can explore even more tax deductions on the IRS website.
If you run your own business, check out these common tax deductions for freelancers.
Pros and Cons of Tax Credits
Tax credits are largely a good thing, as they reduce your overall tax burden. But they also have some drawbacks. Let’s look at the pros and cons:
Pros
• Reduces your tax bill
• May result in a refund
• Often designed for moderate- to low-income families
Cons
• Strict eligibility requirements
• Can delay your refund when you claim them
Recommended: How to File for a Tax Extension
Pros and Cons of Tax Deductions
Similarly, tax deductions serve a useful purpose in filing taxes, but they also have their own set of pros and cons:
Pros
• Reduces your tax bill
• The standard deduction is easy to claim
• Useful for self-employed individuals with business expenses
Cons
• Lots of paperwork (itemized deductions)
• Weighing the standard vs. itemized deduction can be complicated
• Won’t generate a refund
Recommended: How to Prepare for Tax Season
Tax Credits vs. Deductions: What’s the Difference?
Let’s break down the differences between tax credits and tax deductions:
While nearly everyone can qualify for the standard deduction, tax credits are actually the more effective way to lower your tax bill. But the best part? You can utilize both tax strategies when you file.
Tips for Using Tax Credits and Deductions
Ready to file your taxes? Here are some tips for using tax credits and deductions:
• Research eligibility requirements online: The IRS website has useful tools to help determine if you qualify for specific tax credits and deductions.
• Gather all your paperwork: Taxes require a lot of forms, documents, and receipts. When claiming credits and deductions, it’s important to have the paperwork (whether printed or digital) to prove your eligibility.
• Consider using tax software or an accountant: Taxes can be overwhelming. If your situation is complex, you may benefit from tax software or a tax professional.
Recommended: Types of Payroll Deductions
The Takeaway
Tax credits and tax deductions can both lower your overall tax burden. Tax credits reduce what you owe dollar-for-dollar while tax deductions reduce the amount of income you owe taxes on. If you’re eligible, you can take advantage of both tax strategies when you file.
3 Money Tips
1. Direct deposit is the fastest way to get an IRS tax refund. More than 9 out of 10 refunds are issued in less than 21 days using this free service, plus you can track the payment and even split the funds into different bank accounts.
2. An emergency fund or rainy day fund is an important financial safety net. Aim to have at least three to six months’ worth of basic living expenses saved in case you get a major unexpected bill or lose income.
3. If you’re faced with debt and wondering which kind to pay off first, it can be smart to prioritize high-interest debt first. For many people, this means their credit card debt; rates have recently been climbing into the double-digit range, so try to eliminate that ASAP.
FAQ
Between a tax deduction and tax credit, which lowers your bill more?
A tax credit lowers your tax bill dollar-for-dollar and may even result in a refund. A tax deduction only reduces the amount of money you owe taxes on. For example, a $1,000 tax credit takes $1,000 off your tax bill. A $1,000 tax deduction reduces your taxable income by $1,000; the actual reduction in tax depends on your tax bracket.
Do more people utilize tax credits or tax deductions?
Most tax filers can claim the standard deduction, but not everyone qualifies for tax credits. Thus, it is more likely that you’ll use a tax deduction on your tax return than a tax credit. That said, it is possible to use both credits and deductions to lower your tax bill.
Can I claim both deductions and tax credits?
Yes, you can claim both tax deductions and tax credits on your tax return, as long as you qualify for the deductions and credits you claim.
Learn More:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
SoFi members with direct deposit can earn up to 3.75% annual percentage yield (APY) interest on Savings account balances (including Vaults) and up to 2.50% APY on Checking account balances. There is no minimum direct deposit amount required to qualify for these rates. Members without direct deposit will earn 1.20% APY on all account balances in Checking and Savings (including Vaults). Interest rates are variable and subject to change at any time. These rates are current as of 12/16/2022. Additional information can be found at http://www.sofi.com/legal/banking-rate-sheet
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
More from MediaFeed:
9 smart ways to pay off student loans
No one ever wants to talk about the unglamorous work that goes on behind the scenes, but it’s the unspoken progress that makes or breaks every successful business owner, athlete, or creative person. It is helpful to have this mindset and to think about student loan repayment like any other big feat worth accomplishing.
It begins in knowing that paying down student loans in a way that is financially smart and effective takes time and effort, most of which lies in the preparation — the proper planning, budgeting and education will make tackling your student loans during the next decade or more so much easier.
While there is no one single smartest way to pay off student loans, there are steps that you can take that will put you in the best position to pay off your student loans on a timeline and with terms that work best for you. In addition to understanding your student loans, your goal should be to build an overall financial plan that includes your loans.
Related: Why your student loan balance never seems to decrease
9 ways to pay off student loans
If you want to understand how to repay student loans in the smartest and most financially responsible way possible, here are nine steps to implement in your loan repayment plan.
jacoblund / istockphoto
Keeping track of all of your student loans and other sources of debt can be tricky, especially if you are a recent graduate. Your first step should be to organize them on a list. On your list should include the loan service provider (the bank, federal government, or private lender), amount of the loan, monthly payment, interest rate and when the loan will be paid off in full.
If you aren’t sure what your monthly payments on your student loans will be, you can use our student loan calculator. This calculator estimates how much you could be paying each month on your student loans.
If you have credit card debt or other personal loans, include these on your list. With all of your sources of debt, mark on a calendar the date that the monthly payments are due.
While you always need to make the monthly minimum payments on all debts (unless your student loans are within their grace period or are in forbearance), listing them out allows you to identify which debts to pay off first. If you have high interest credit cards adding up each month, a credit card consolidation loan may be a great option to look at.
Once your credit cards are paid off, you’ll want to think about whether your goal is to pay your loans off quickly, or to simply make the monthly payments until the loans are done. The former is a good way to save on interest over time.
Some folks do prefer to pay only the minimum monthly amount on their student loans so that they can save and invest while they pay down their student loans.
If the interest rates on your student loans are low, this may be a good reason to start investing with your extra funds, in order to take advantage of compound returns. If the interest on your loans is higher than you could reasonably expect to make investing, it might make more sense to pay off your loans first. Which option is right for you is a completely personal decision.
DepositPhotos.com
No matter who you are, learning how to budget your money should be on the top of your financial to-do list. It takes time and effort to develop a budgeting system that works for you, but it is doable, and totally worth it. To get started, track your monthly cash inflows and outflows for two months.
Total up how much money you spent in each category, including debt payments like student loans. Once you have a general idea of what you’re spending in each category, you can begin to build a budget framework. For example, if you spend $260 on groceries one month and $300 the next, you can now set yourself a realistic grocery budget. Leave room for annual, bi-annual and quarterly expenses, as well as incidentals.
With a budget that is built to include student loan payments, you’ll be more equipped to make all of your payments on-time and know how much is available to spend on other needs and wants. Also, understanding exactly how you’re spending allows you to identify the areas where you’re overspending.
For example, a close look at your budget could reveal that you’re spending more than you realized on dining out, subscriptions, clothing, or even rent — and gives you the power to make a change. And by saving money in other categories, you’ll free up money to apply to your financial goals.
DepositPhotos.com
Hopefully, your student loans are already set up to be automatically deducted from your bank account. (This is a good strategy for all your monthly bills.) If they aren’t, contact your student loan service provider to set it up. This way, you’ll never miss a payment because you forgot or are somewhere where you can’t access the internet.
Remember, every time you miss or are late on a payment, it negatively impacts your credit score. Bad credit could preclude you from opportunities in the future, such as being able to refinance your loan to a lower interest rate. Take every extra precaution to make sure your loans get paid on time.
As an added bonus, some service providers offer a discount, usually.25%, if you arrange to pay by automatic payments. When you sign up, be sure to ask if such a discount is available.
Youngoldman / istockphoto
Most student loans allow you to pay more than the minimum monthly payment, and doing so can be a great strategy if your goal is to pay back your loan faster than the stated term. In addition to a faster payoff, you can save on interest over the life of the loan. Even small amounts make a difference. One drawback is that some providers have prepayment penalties. When you contact you student loan service provider, be sure to ask if they charge such fees.
To do this, call your loan service provider to adjust your automated monthly payment to a higher amount, and clarify that you want that money dedicated to the principal of the loan. Make sure, after the next month’s payment, that the money was indeed put towards the loan’s principal.
Looking for more advice on paying down your student loans? SoFi’s student loan help center offers tips, guides and resources on all things student loans.
Deposit Photos
Increasing your monthly payment isn’t the only way to put a dent in your loans; at any point, you are allowed to make a lump sum payment towards the principal of your loan. This is a great way to speed up the student loan repayment process without having to commit to paying more each and every month.
You may have more opportunities to do this than you think: Utilize your tax refund, holiday money, birthday money, work bonuses or inheritance money. Additionally, putting income from a side hustle or other passive income towards student loans could be a financially rewarding move over the long-term.
Depositphotos
Most federal student loans come with a standard, ten-year repayment plan. With federal loans, there are other options for repayment plans with lower monthly payments, calculated using your income. These plans lower your monthly payments by extending the length of your loan, usually from ten years to twenty or more years.
When you choose one of these options, it is important to know that even though your monthly payments are lower, you can end up paying more in interest over time. Therefore, it’s not a great choice if you want to pay off your loans quickly or pay as little in interest as possible, but it is available to those who are having trouble making their monthly payments.
If you are planning to utilize the Public Student Loan Forgiveness program for your federal loans, you will need to select one of the income-dependent repayment programs.
insta_photos/istockphoto
When you refinance a loan or multiple loans, a lender pays off your current loan(s) and provides you with a new loan, ideally at a lower rate. A lower interest rate could mean savings over the life of your loan.
Though refinancing might not be the right option for everyone, it’s a strategy that every student loan holder should, in the very least, research and consider. Also, understand that while refinancing can consolidate multiple loans, federal loan consolidation is a different process. With federal loan consolidation, the government bundles your loans together into one, using a weighted average of the interest rates.
If you are able to refinance to a lower rate, you will want to ask yourself whether the purpose is to lower your monthly payment but keep the same term, freeing up some money in your monthly budget, or to keep your monthly payment the same (or higher) and to shorten your term so that you can pay off your student debt faster.
Exploring refinancing with a private lender usually doesn’t take a lot of time and it doesn’t cost you anything.
Drazen Zigic/istockphoto
With all raises, you can use the extra income towards your financial goals. This could mean increasing the monthly amount you pay towards your loans, making the occasional lump sum payment towards the loan with the extra windfall, and/or saving and investing money for your other long-term financial goals.
How much money you earn is an important factor contributing to your financial stability and ability to pay down your student debt. While budgeting is important, so is knowing your worth and asking for more when you deserve it. If you haven’t already, start keeping track of your successes now so that at your next compensation conversation, you’re loaded with concrete data on why you deserve a bump.
fizkes / istockphoto
Although not yet as widespread as retirement or healthcare benefits, more employers are offering student loan repayment help as a benefit to attract and retain employees.
Depending on your personal situation, student loan repayment help could be as important than a raise or other benefits. Whenever you’re comparing job offers, it’s critical to understand and compare benefits packages, because although they’re not flashy like a big salary or company equity, benefits can be just as valuable.
If you’re looking for a new job, include student loan repayment help in your search. While it shouldn’t be your only consideration, it’s great to have an idea of what you’re looking for in an employer.
Learn more:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
Notice: SoFi refinance loans are private loans and do not have the same repayment options that the federal loan program offers such as Income Based Repayment or Income Contingent Repayment or PAYE. SoFi always recommends that you consult a qualified financial advisor to discuss what is best for your unique situation.
Depositphotos
Featured Image Credit: DepositPhotos.com.
