Tax Deductions vs Tax Credits

Today we’ll explore the differences between tax credits and tax deductions. While the terms are often used interchangeably, there is a significant difference in your tax bill depending on which one we are talking about.

Tax deductions reduce your taxable income, but tax credits reduce your bill dollar for dollar.

Tax deductions reduce your taxable income. In other words, the deduction reduces the amount of taxable income that is subject to tax. If, for example, you are in the 32% tax bracket, a $10,000 deduction saves you $3,200.

Tax credits, on the other hand, provide a dollar for dollar reduction in your tax liability. A $10,000 tax credit reduces your tax bill by $10,000.

Here’s an example of how this would work for a married family earning $400,000:

The Trouble with Tax Credits

So it sounds like tax credits are always the best answer. Not so fast. Tax credits come in two “flavors”: Refundable and Non-refundable.

Refundable credits are great because regardless of your tax liability you’ll receive a refund, even if it exceeds your tax liability.

Non-refundable credits, on the other hand, are sometimes lost all together if your liability isn’t high enough. Other times they can be carried forward to future years until they are used.

Refundable Tax Credits

While most tax credits are non-refundable, there are a few select credits that are refundable. Here are a couple examples:

Earned Income Tax Credit

The Earned Income Tax Credit (EITC) provides substantial support to low- and moderate-income working parents who claim a qualifying child based on relationship, age, residency and tax filing status requirements. For 2023, the maximum AGI for a married couple with two kids is $53,120 to qualify for this credit.

Additional Child Tax Credit

The Child Tax Credit will revert back to $2,000 for 2023 and $1,600 of that credit is considered refundable for 2023. The full credit is available for single filers with up to $200,000 (married $400,000) of annual income. 

Non-Refundable Tax Credits

Non-refundable credits aren’t as beneficial as refundable credits, but some allow for credit carryover to future tax years. Here are a few examples:

Adoption Tax Credit

The IRS allows a credit for adoption fees, court costs, attorney fees and traveling expenses related to the adoption of a child. The credit is income sensitive and fully phases out at about $280,000 for 2023. While the credit is nonrefundable, it can be carried forward for five years to offset future tax liability.

Electric Vehicle Tax Credit

You can receive up to a $7,500 tax credit for purchasing the correct type of electric vehicle in 2023. The credit is available for modified adjusted gross income of up to $150,000 single and $300,000 joint. There are actually two sets of rules for 2023 as we wrote about last month, so be sure to check the fine print before buying. This credit is unable to be carried forward for use in a future tax year.

Foreign Tax Credit

If you paid foreign taxes to a foreign country or U.S. possession and are subject to U.S. tax on the same income, you may be able to take either a credit or deduction for those taxes. This most often occurs when an investment you purchased has stock of a foreign company. You’ll see this detail on your year end Form 1099 consolidated investment statement. Unused foreign tax credits can carry forward to future years.

Home Energy Tax Credits

When you purchase certain energy efficient products, you are eligible for a tax credit. Examples include: 

• Exterior doors, windows, skylights and insulation materials
• Central air conditioners, water heaters, furnaces, boilers and heat pumps
• Biomass stoves and boilers
• Solar, wind and geothermal power generation
• Solar water heaters
• Fuel cells
• Battery storage (beginning in 2023)

In most cases, the credit amount starts at 30% of your purchase price, but several categories above have maximum credit limitations that are quite a bit smaller than 30% of your purchase price. You can find more detail on the IRS website for Energy Efficient Home Improvement Credit and Residential Clean Energy Credit.

While we’ve touched on a few of the common examples of tax credits, there are a whole host of other credits that may apply and are worth knowing about. If you have a question on whether a credit would apply to your situation, please feel free to reach out.