Do you know the difference between a tax credit and a tax deduction?
If so, you may be in the minority compared to most Americans because one of the biggest misunderstandings about taxes is the idea of a tax credit vs. a tax deduction.
They both put your money in your pocket but in vastly different ways.
Tax Credit vs. Tax Deduction
Here's the difference between a tax credit and a tax deduction:
- A tax credit reduces how much tax you owe to the IRS and is a dollar for dollars reduction in tax liability. The Child Tax Credit is worth up to $2,000 per qualifying child and if you qualify, it will reduce how much you owe on your taxes by $2,000.
- A tax deduction reduces how much of your income is subject to taxation, and usually only if you itemize your tax deductions. Charitable contributions are tax deductions so if you make a $2,000 donation to a qualifying charity, you reduce your taxable income by $2,000. Your taxes will go down based on your tax bracket. If you're in the 24% tax bracket, your taxes will be reduced by $480.
So in a hypothetical scenario in which you could get either a $2,000 tax credit or a $2,000 tax deduction, you want the tax credit. It reduces your tax liability the most.
With tax credits, there's also another distinction – is the tax credit refundable?
Refundable means that you will get the full value of the credit, even if your tax liability is reduced to below zero. For example, the Child Tax Credit is refundable so even if you owed very little in taxes, and the credit put your tax liability in the “negative,” where the IRS owes you money, you would get all of the credit.
Let's say you qualify for a $2,000 Child Tax Credit and you owed $500, then the IRS would send you $1,500. If the Child Tax Credit were not refundable, you would get nothing.
Claim Standard or Itemized Deductions?
When you file your taxes, you often have to make a big decision – do I claim the standard deduction or should I itemize my deductions?
With a tax credit, you get it no matter what. No decision required.
With a tax deduction, you only get it if you itemize your deductions. When you file your taxes, you can always claim a standard deduction. The standard deduction is meant as a catch-all and you don't have to do anything extra to get it – everyone can take it.
The amount you can deduct will be based on your filing status for 2020:
- Single: $12,400
- Married filing jointly: $24,800
- Married filing separately: $12,400
- Head of household: $18,650
If you have a series of deductions that, in total, exceed the standard deduction then you will want to itemize them on a Schedule A. In other words, let's say you're a single filer, if you think you have more than $12,400 in total tax deductions, you will have to itemize them to get the full deduction. This also means you have to retain the paperwork and proof, just in case your tax return is audited. No proof required for a standard deduction.
You almost always want to use the method that gets you the highest tax refund (don't claim the standard deduction because you think you'll get audited, it's extremely unlikely) but you can see now why a tax credit is so much better. 🙂
But when it comes down to the numbers – this is why a tax deduction is less attractive than tax credit – you need a sum total of deductions greater than the standard deduction. With a tax credit, you just get it if you qualify.
Some tax deductions are “above-the-line” deductions, which means you can claim them even if you don't itemize your deductions. The CARES Act made cash donations up to $300 an “above-the-line” deduction so you can claim it even if you take the standard deduction. You can claim up to $300 in cash contributions this way.
$1,200 Stimulus Check
The $1,200 stimulus check in the CARES Act was an advance on a refundable tax credit. Now that we know what a refundable tax credit is, let's cover the “advance” part. It simply means that the IRS will send you a check for the tax credit now and then sort out the details next year when you do your taxes.
What gets tricky is that the tax credit is based on 2020 tax year information. This is information they won't get until you file your taxes in 2021. But they need to send the checks today… so what's the solution?
The amount of the check they send to you today is based on 2018 or 2019 tax information.
Then, after you file your taxes in 2021 for this year, they will adjust your tax refund accordingly. They have said that if they overpaid, they won't claw back any money. If they underpaid, you should see the difference added to your tax refund.
Now you know the difference between a tax credit and tax deduction!