Tax Deduction Vs. Tax Credit: What’s The Difference?

Many look at the new year as a fresh start. It can be a way to put the previous year behind you and focus on the future. But the new year also means that tax time is approaching. 

Workers in the United States will receive their W-2 forms from their employers, while contractors will collect 1099 forms from clients to prepare for the April 15 tax deadline.

There’s no doubt that taxes can be a confusing topic. The tax code isn’t exactly light reading. One of the most commonly confused parts of tax law — and a piece that affects all taxpayers — is the difference between tax deductions and tax credits. Both can help to reduce your tax burden but in very different ways.

 

Throughout the year, tax management is important. Just within the scope of investing, it can increase your portfolio’s return by 1% per year. While that may not sound like very much, it can lead to a nearly 40% difference in the value of your portfolio over 35 years. That translates to retiring earlier, traveling, helping your kids pay for college, or meeting the financial goals that matter to you. Read up on 5 Tax Hacks for Investors with our free guide.

What is a Tax Deduction?

A tax deduction reduces your taxable income. When you file your income tax return, you can claim any deduction that you’re eligible for. Then, when it’s actually time to calculate how much you owe, your tax rate is applied to a smaller portion of your income. As a result, you pay less in taxes.

When you file your taxes, the IRS gives you two options: You can either claim the standard deduction ($12,400 per person for the 2020 tax year) or you can itemize your deductions. It might make sense to itemize deductions if the total amount of deductions you’re eligible for adds up to more than $12,400.

Let’s look at a quick example. Imagine someone makes $50,000 per year. When they file their tax return, they claim the standard deduction. Now instead of paying taxes on the full $50,000, they only pay taxes on $37,600.

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