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There Are Key Differences Between Tax Credits and Deductions. What to Know Before Filing Your Return

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  • Tax credits slash your liability on a dollar-for-dollar basis, whereas deductions reduce income subject to tax.
  • The most valuable write-offs are typically above-the-line deductions and refundable tax credits.
  • However, you'll need to run the numbers to see which options are best on your return, financial experts say.

If you're eager to slash your tax bill, two popular methods are claiming credits and deductions on your return. While both can reduce your balance, these write-offs have key differences, which ultimately affect your bottom line.

Credits lessen your liability on a dollar-for-dollar basis, whereas deductions reduce income subject to tax, said certified financial planner Judson Meinhart, manager of financial planning at Parsec Financial in Winston-Salem, North Carolina.

For example, let's say you owe the IRS $5,000 at tax time. In that scenario, a $2,000 tax credit drops your bill to $3,000.

However, the value of a deduction depends on your marginal taxes. If you're in the 24% bracket, for example, a $2,000 deduction is worth $480 — your tax rate multiplied by the write-off. 

"If you can take either a deduction or credit for the same expense, do the math to see which offers the better result," said David Flamer, a CPA at the firm in his name in Agoura Hills, California. "Otherwise, there could be taxes left on the table."

Here's how tax credits and deductions work on your tax return.

You start with gross earnings and subtract so-called "above-the-line" deductions for your adjusted gross income, or AGI. 

These deductions are unique because you can claim them regardless of whether you take the standard deduction or itemize, Flamer said.

Some of the most common above-the-line deductions are retirement contributions, student loan interest and health savings account deposits, with some having phase-outs by income level. 

Next, you reduce AGI by either the standard deduction or itemized "below-the-line" deductions, such as mortgage interest, charitable gifts, medical expenses and state and local taxes capped at $10,000. 

However, you don't claim these write-offs unless the total exceeds $12,550 for individuals and $25,100 for married couples filing jointly in 2021.

Starting in 2018, former President Donald Trump's signature tax overhaul nearly doubled the standard deduction, so you're less likely to itemize, Meinhart said.

Indeed, almost 90% of taxpayers now take the standard deduction, according to the IRS.

After subtracting the standard or itemized deductions from AGI, you reach taxable income, the number used to calculate your bill.

But first, you can claim tax credits, subject to income limits, which may zero out your balance or boost your refund.

"Some tax credits are worth more than others," Flamer said. 

Tax credits can be non-refundable, slashing your liability to zero, or refundable, offering a payment beyond what you owe. And partially refundable tax credits offer a combination of the two.

For 2021, refundable tax credits may include the earned income tax credit for low- to moderate-income families, the child tax credit, the child and dependent care credit and more.

What to know before filing

While it's easy to claim tax credits and deductions through filing software, it's important to make sure you're eligible, Flamer said, and it pays to educate yourself about the benefits.

The chances of an audit are slim, but certain write-offs are more likely to attract scrutiny from the IRS. Experts suggest keeping a copy of tax receipts for seven years to be safe.  

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