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Tax deduction vs tax credit: What’s best for you?

Getting a decent tax refund is an awesome way to save your wealth and divert into investments that work for you. But what is a tax deduction and how is it different from a tax credit?
Tax deduction vs tax credit
Tax deduction vs tax credit: What’s best for you?
Tax credits and tax deductions both work to lower your overall tax bill. A tax credit is a direct dollar amount that you receive as a discount on your actual tax bill. There are two main types of tax deductions that you can claim - a standard deduction or an itemized deduction.
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Every American citizen wants to know how to save the most on taxes. Luckily, the IRS and state governments have provided a lot of ways to save on income tax and reduce your total tax liability. Getting a decent tax refund is an awesome way to save your wealth and divert into investments that work for you. Now getting to the point. What is a tax deduction, and how is it different from a tax credit? In the simplest of terms – a tax deduction reduces the overall amount that you are taxed on (before you generate your tax bill) – and a tax credit directly cuts your final tax bill.

Tax credits and tax deductions both work to lower your overall tax bill, but in different ways.

What is a tax deduction?

The United States has a progressive tax system. This means that people belonging to different income groups are liable to pay varying amounts of tax. 

The tax amount increases as your Adjusted Gross Income (AGI) increases, resulting in a higher tax slab and a larger tax bill. 

Lowering your Adjusted Gross Income (AGI) can lead to a reduction in your tax bill. By utilizing tax deductions that decrease your AGI, you can effectively lower the amount of taxes you owe. This means the IRS acknowledges that, despite having a high income, you have rightfully claimed deductions to reduce your taxable income. In turn, this results in a lower overall tax bill. Deductions frequently contribute to a reduced tax burden. Compare this to using coupons at a store while the cashier is tallying your purchases. This helps you save money bit by bit, leading to a reduced bill amount.

What is a tax credit?

After you have submitted your AGI and determined your placement in a specific tax bracket, your tax bill is generated. A tax credit is an exact dollar amount that you get as a discount on your actual tax bill. Imagine it as purchasing items at the store at full price and then receiving a flat discount, which ultimately reduces the total amount you owe.

How do I claim tax deductions?

There are two main types of tax deductions that you can claim – a standard deduction or an itemized deduction. You only get to choose, so choose wisely. The best way to do this is to calculate how much you’ll owe in both scenarios and pick the option where you save more. This is different for different tax filers depending on many factors.

What is a standard deduction?

A standard tax deduction is the easier way to go about reducing your taxable income. It’s a direct, fixed-dollar amount that you subtract from your Adjusted Gross Income (AGI). How much is this amount? It depends on your tax filing status.

What are itemized deductions?

Itemized tax deductions are a bit more complicated than standard deductions but can end up saving you a lot more in taxes if you meet certain criteria. You run through an itemized list of potential tax-discount allowances – and use the ones that describe your situation. There are many hundreds of such tax-itemized deductions, and different people qualify for different ones depending on their situations.

Itemized deductions and tax credits you can claim:

  • Medical and dental expenses: You can deduct dental and medical expenses if they are over 7.5% of your AGI
  •  Home equity loan interest: If you’ve used a home loan to purchase, construct, or renovate improvements to your main or secondary home – you can claim the interest on this loan as an itemized deduction
  •  State and local taxes: Property taxes, income tax, sales tax of the local county that are being claimed as itemized deductions cannot exceed $10,000 (or $5,000 for taxpayers that are married but filing separately). No amount over $10,000 can be claimed under this heading.
  •  Interest on student loans deductions: You can deduct up to a whopping $2,500 from your AGI depending on how much interest you’ve paid on your student loans so far.
  •  Deduction for contributions to your 401(K) account: Up to $19,500 that’s channeled directly into a 401(k) account can be directly deducted from your AGI. Applicable for employees and self-employed individuals.
  •  Deduction for charitable donations: Donations like cash, property, clothes, cars, etc. given to charity can be deducted from your taxable income.
  •  Deduction for Mortgage Interest: This useful little deduction actually reduces your federal tax liability by subtracting the amount of mortgage interest from the amount of overall taxable income.
  •  “American Opportunity” credit: This allows the tax filer to claim the full first $2,000 spent on books, tuition, fees, and related equipment – and 25% of the next $2,000 spent in the same avenues.
  •  Child” tax creditThis applies to dependent children and non-child dependents as well. A claim can be made for up to $2,000 per child dependent and $500 per non-child dependent.
  •  “Child and Dependent Care” tax credit: You can save up to 35% (up to $3,000) of costs involved in child care such as day-care for dependent children (below 13) and a spouse/parent that’s unable to care for themselves so that’s up to 35% of $6,000 for two or more than two dependents. The rules in 2021 increase this to 50% of $8,000 for one and $16,000 for two dependents (or more).
  •  “Adoption” tax credit: If you have adopted one or more children in 2020, you can claim up to $14,300 of the adoption costs per adopted child. If you’ve adopted one more child in 2021, you can get up to $14,440 per child.
  •  Earned income tax credit: This is a popular tax credit that depends on your income, number of children, and marital status. In 2020, it can save you up to $6,600 and in 2021, it can save you up to $6,728.

While the above deductions and credits are not an entire list of all the ways you can save on taxes, they are the most common and popular itemized options that tax filers use. Your individual case may allow you to claim further obscure deductions and credits from the hundreds of options out there. Use Beem to get a quick and accurate estimate of your federal and state taxes and get the maximum refund.

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Neehara Sanjivi

Neehara Sanjivi

A writer whose interests range from poetry and origami to neuroscience and anthropology, Neehara has a master’s degree in psychology and online tutors undergrad students in her spare time. Her life is overrun by cats, plants and the occasional flock of pigeons.

This page is purely informational. Beem does not provide financial, legal or accounting advice. This article has been prepared for informational purposes only. It is not intended to provide financial, legal or accounting advice and should not be relied on for the same. Please consult your own financial, legal and accounting advisors before engaging in any transactions.

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