Tax Deduction vs Tax Credit
Mar 21, 2022![](https://kajabi-storefronts-production.kajabi-cdn.com/kajabi-storefronts-production/blogs/18457/images/NfOUu2KZTti9HbWzgR4i_51140726_s.jpg)
A while back, there was a video that went viral of a father teaching his 3-year-old daughter the meaning of taxes. They are each holding ice cream cones, and the dad says, “Before you eat it, I need to take taxes.” He then proceeds to take a big bite.
“Social Security and Medicare,” he takes a smaller bite. The kid is now tearing up.
“One more bite, this is a small one, this is city taxes,” he says as he takes a final nibble.
“Now enjoy!” proclaims the dad.
The kid is mortified.
If you are trying to find a way to save money or reduce losses, you must consider tax minimization. In fact, dollar for dollar, managing your tax liability might provide a better return on investment than simply chasing investment returns.
When we talk about taxes, there are many nuances and details that are hard to decipher for many of us. The truth is, like many things in finance, taxes can be quite simple – it’s people who make it complicated.
One source of common confusion is the difference between a tax deduction and a tax credit.
A tax deduction is “income” you can “deduct” from your “adjusted gross income”. Deductions reduce your taxable income. Think of a tax deduction like money you have earned (and spent) that the government says, “OK, we like what you’ve done, so we aren’t going to tax you on that money.”
Examples of tax deductions include saving for retirement, qualified childcare expenses, and medical expenses above certain thresholds.
Tax deductions are great, but tax credits are spectacular!
Credits apply to your taxes due and are like dollar-for-dollar rebates. For example, if you owe $10,000 and are eligible for a $500 credit, then your taxes due now will be $9,500.
Tax credits come in two flavors: refundable and non-refundable.
Refundable credits mean that if, after applying all applicable tax credits to your tax bill, the amount of tax you owe is a negative number, the IRS will kindly “refund” you the “excess” amount “credited/paid” to the extent of your allowable refundable credits.
Non-refundable credits, on the other hand, will simply reduce your tax bill. The Child Tax Credit is an example of a refundable tax credit while the Solar Investment Tax Credit is non-refundable.
Getting back to tax deductions, which are more common than tax credits, it’s important to know the key deductions that can go a long way toward reducing your tax bill.
- Standard deduction. Individuals and couples often take the standard deduction when their itemized deductions do not add up to a higher number. It is estimated that 90% of filers choose the standard deduction. Those more likely to itemize are filers that have high charitable contributions and medical expenses.
- Retirement savings deduction and the Saver’s Tax Credit. Contributions to a regular 401(k) plan and Traditional IRA (and other pre-tax retirement accounts) may be deductible. Moreover, you might be eligible for an additional tax credit if your income is below an annual limit.
- HSA deduction. Contributions to a Health Savings Account are tax-deductible.
- 529 deduction. Saving for college offers a tax deduction, too!
- Qualified child and dependent care expenses. Young parents paying for childcare can qualify for a tax deduction. Such is also the case when you incur costs associated with the care of elders.
- Qualified Business Income (QBI) deduction. Small business owners with income below an annual limit can take the valuable QBI deduction.
Several years ago, Congress doubled the standard deduction amount and greatly reduced the mortgage interest deduction. Those changes effectively eliminated the need for itemized deductions for many taxpayers. That’s why so many Americans simply take the standard deduction these days.
Getting your taxes done right and reducing the amount you owe is an important task each year. In retirement, we lose many of the credits and deductions we had in our working years – which can increase our effective tax rates.
As retirees, we need to treat taxes the same way we treat market losses – as a scourge to be avoided. In retirement, every penny counts, especially when the market is down, or volatile and the future is uncertain.
For more information about how to avoid unnecessary taxation, check out Chapter 6 in Living with Financial Anxiety. As well as our How to Pay Zero in Taxes in Retirement guide.
Have Questions? Get the answers you need.