What You Need to Know about Tax Deductions and Credits

It’s easy to confuse tax deductions and credits since they both reduce the amount of money you owe in taxes. But there are important differences between them—specifically, in how they work to reduce your tax liability. 

Tax deductions

A tax deduction reduces your taxable income (the amount of your income that’s taxed by the federal government). If you lower your taxable income, you could reduce the amount of tax you have to pay for a given year.

The standard deduction is the most common. The amount is adjusted each year and is based on your filing status (e.g., single, head of household, etc.).

Other potential deductions are listed on IRS Schedule A and Schedule 1 on Form 1040. Some other common deductions include:

• Health Savings Account (HSA) contribution
• Traditional IRA contribution
• Charitable contribution
• Mortgage interest
• State and local tax

Keep in mind that many deductions come with certain restrictions and eligibility rules. So just because a tax deduction exists doesn’t mean you can automatically claim it on your tax return. Always confirm the qualification rules with the IRS, your Ayco coach or a professional tax preparer.

A closer look at how a tax deduction works

A tax deduction lowers your taxable income. But by how much? It depends on the limit or size of the particular deduction you’re claiming. A $6,000 deduction, for instance, would lower your taxable income by $6,000.

Deduction amounts vary. Take the deduction limits for traditional IRA and HSA contributions, for example. If you’re qualified to take the full deduction for both during the 2021 tax year: The full deductible amount for contributions to a traditional IRA is $6,000 (or $7,000 for those 50 or older). And the full deduction for HSA contributions is $3,600 (for individuals).

Tax credits

Remember how a deduction lowers your taxable income? Well, a tax credit directly lowers your tax liability, dollar-for-dollar. So let’s say you end up owing $5,000 in taxes this year, and you’re eligible for a $2,000 tax credit. The tax credit would lower your tax bill to $3,000.

Unlike a tax deduction, the value of a tax credit is not tied to your income tax bracket. So a $2,000 tax credit is worth exactly $2,000 in terms of how much it can save you on your taxes.

Similar to tax deductions, you might not qualify for every tax credit you come across while doing your taxes. So be sure to get the details for any credits you wish to claim from the IRS, your Ayco coach or a professional tax preparer.

A closer look at how a tax credit works

There are two different types of tax credits: nonrefundable and refundable.

A nonrefundable tax credit can only reduce the amount of taxes you owe up to the amount of your tax credit. Any unused portion of the credit won’t be refunded to you.

Say you owe $500 in taxes and you qualify for a $2,000 nonrefundable credit. You could use $500 of that $2,000 credit to bring your tax bill to zero, but you wouldn’t get the $1,500 that’s left over in the credit ($2,000 - $500). In short, any unused amount of a nonrefundable credit is forfeited.

Some examples of a nonrefundable credit include:

• Savers credit
• Foreign tax credit
• Adoption tax credit

With a refundable tax credit, however, any unused amount of the credit will be refunded to you. So sticking with the previous example: If you qualify for a $2,000 refundable credit and you owe $500 in taxes, the credit could bring your tax bill down to $0 and the remaining $1,500 would be refunded to you. A common example of a refundable credit is the Earned Income Tax Credit.

Next steps

Because most tax deductions and tax credits are subject to eligibility requirements, the IRS typically expects certain documentation with your tax return to show that you’re qualified to claim them. This is why good tax recordkeeping is important (try not to use the “receipts-in-a-shoebox” method).

Also keep in mind that the availability of any tax deduction or credit, along with their eligibility rules, is always subject to change, as Congress has the power to modify or eliminate them. It’s a good idea to check in with the IRS, your Ayco coach or a tax professional if you’re unsure about a certain deduction or credit.

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