Tax Credits vs. Tax Deductions

Tax deductions are deductible from income. For simplicity, lets say you report $30,000 in deductions and the effective tax rate applied to the income reduced by the $30,000 is 22%. Your tax savings will be about $6,600. Using an effective tax rate is the result of assuming the $30,000 falls in multiple tax-brackets like the 15% and 25% marginal brackets. It may be easier to practice this math only using a marginal tax bracket, such as 25%.

Tax credits are not deductible from income. They directly reduce tax, which is far more effective than deductions. Tax credits reduce tax on a dollar-for-dollar basis. In the above example, assume the tax liability after income and deductions equals $8,000. You qualify for $2,000 in credits, which directly reduces your tax liability to $6,000. At the 22% effective tax rate used above you would need $9,090 in additional deductions to reduce your liability by that same $2,000.

A tax credit absorbs the full weight of the tax liability instead of simply reducing income. Here is a list of tax credits to watch out for. Tax credits may become unavailable when the taxpayer’s income or AGI exceeds specific phase-out limits.

Child Tax Credit – Maximum of $1,000 per qualifying child.

Child and Dependent Care Credit – Expenses paid for care of children under 13 or a disabled spouse / dependent. The credit is limited and a percentage of qualifying expenses.

Adoption Credit – Maximum of $10,000 for qualifying expenses paid to adopt an eligible child.

Earned Income Credit – Low-income working family / individual credit. Credit depends on family size. This is a refundable credit, which produces a refund even with a $0 tax liability.

Education Credit – Credit for students with higher education expenses. Two credits offered are the Hope Credit and Lifetime Learning Credit. Taxpayer must choose one of the two in the tax year used.

Retirement Savings Contribution Credit – Contributions to qualified retirement plans and IRAs (TIRA, Roth, SIMPLE, SEP) may produce credits for a percentage of the contribution. Eligibility depends on AGI and dependency status.

Some other credits to watch for:

• Credit for the Elderly and Disabled  §22
• Work Opportunity Credit §51
• Welfare-to-Work Tax Credit §51A
• R&D Credit §41
• Rehabilitation Tax Credit §47
• Low Income Housing Credit §42

If one or more of these credits apply to you, make sure you are eligible for the credit. If your AGI is expected to be higher than the limit, explore some tax planning opportunities to reduce your AGI and qualify for the credit. Examples like this magnify the importance of tax planning before tax-season, not after!