Understanding Tax Credits Versus Deductions

Tax credits are some of the most valuable tools around to help cut your tax bill. But figuring out how to use these credits on your tax return can get complicated very quickly. Here's what you need to know.

To help illustrate the difference between a credit and a deduction, here is an example of a single taxpayer making $50,000 in 2022:

Tax Deduction Example: Jack earns $50,000 and owes $5,000 in taxes. If you add a $1,000 tax deduction, he'll decrease his $50,000 income to $49,000, and owe about $4,800 in taxes.

Result: A $1,000 tax deduction decreases his tax bill by $200, from $5,000 to $4,800.

Tax Credit Example: Now let's assume Jack has a $1,000 tax credit versus a deduction. His tax bill decreases from $5,000 to $4,000, while his $50,000 income stays the same.

Result: A $1,000 tax credit decreases his tax bill from $5,000 to $4,000.

In the above example, your tax credit is five times as valuable as a tax deduction.

Credits are generally worth much more than deductions. However there are several hurdles you have to clear before being able to take advantage of a credit.

To illustrate, consider the popular child tax:

Hurdle #1: Meet basic qualifications

You can claim a $2,000 tax credit for each qualifying child you have on your 2022 tax return. The good news is that the IRS's definition of qualifying child is fairly broad, but there are enough nuances to the definition that Hurdle #1 could get complicated. And then to make matters more complicated...

Hurdle #2: Meet income qualifications

If you make too much money, you can't claim the credit. If you're single, head of household or married filing separately, the child tax credit completely goes away if you exceed $240,000 of taxable income. If you're married filing jointly, the credit disappears above $440,000 of income. And then to make matters more complicated...

Hurdle #3: Meet income tax qualifications

To claim the entire $2,000 child tax credit, you must owe at least $2,000 of income tax. For example, if you owe $3,000 in taxes and have one child that qualifies for the credit, you can claim the entire $2,000 credit. But if you only owe $1,000 in taxes, the maximum amount of the child tax credit you could claim is $1,400.

The bottom line is that tax credits are usually more valuable than tax deductions. But tax credits also come with lots of rules that can be confusing. Please call to schedule a tax planning session to make sure you make the most of the available tax credits for your situation.