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Understanding The Differences Among Tax Credits, Deductions, And Adjustments

When calculating the amount you owe for taxes, keep in mind there are weighty differences between tax credits, deductions, and adjustments. Here’s how to know the difference.

The trouble is, there’s a lot of confusion when talking about these tax “write-offs.” While all three typically result in a lower tax bill, not all write-offs are created equal.

Here’s how to understand the differences between tax credits, deductions, and adjustments.

What are tax credits?

Unlike a deduction or adjustment that serves to reduce your taxable income, a credit directly lowers the amount you owe on your taxes. Since tax credits are responsible for this high-impact reduction on your tax bill, they provide the most benefit when it comes to how much you pay in taxes.

If you’re a parent, you’re likely already familiar with tax credits due to the popularity of the Child Credit, and the Credit for Child and Dependent Care expenses. Governments also offer tax credits to promote specific behaviors, such as for replacing older appliances with new, energy efficient models.

Why tax credits are important

Tax credits are your best shot to reduce your tax liability. When you qualify for a tax credit, you get an exact dollar-for-dollar reduction in the amount you owe.

For example, if you owe $3,000 in federal taxes, a qualifying credit of $2,000 would lower your tax bill to $1,000, which leaves more money in your pocket.

It’s important to understand how they work, and there are three different types of tax credits:

  • Nonrefundable Tax Credits are deducted from your tax bill until the amount you owe equals zero. That means if you owed $4,000 in taxes and got a $4,500 tax credit, you’d end up owing $0 but you don’t get to keep the extra $500 from the credit.
  • Refundable Tax Credits are entirely refundable and provide the highest benefit because, regardless of what you might owe, you get the entire amount of the credit. For instance, if your tax bill was $4,000 and you received a $4,500 tax credit, you’d end up owing $0 plus the extra $500 would be paid to you, too.
  • Partially Refundable Tax Credits fall somewhere between the two. This type of credit can directly lower your tax bill, but it can also lower your taxable income. The American Opportunity Tax Credit is partially refundable, for example. Under this credit, if you’ve already reduced the amount you owe to $0 before using all of the $2,500 partial tax credit, you can take the rest as a refundable credit up to 40 percent of the credit of $1,000, whichever is the lesser amount.

How to spot tax credits

Once you understand the three different kinds of tax credits, you can begin to sort through which ones are most beneficial for you. The IRS website has a generous list of tax credits for individuals based on family size, whether or not you’re a homeowner, and how much you paid for health care or education expenses.

A few tax credits you may already know to include are:

  • Earned Income Tax Credit
  • Low-Income Housing Credit
  • Child and Dependent Care Credit
  • American Opportunity Tax Credit

It’s best to work with a tax professional to determine your eligibility on these and other credits offered by the government. Or, you could use a tax software such as Turbo Tax, H&R Block, or TaxAct.

What are deductions?

When talking about tax “write-offs,” people are usually referring to deductions. As a shortened way of saying itemized deductions, which are also known as below-the-line deductions, tax deductions reduce your tax bill but don’t provide a dollar-for-dollar match like a tax credit does.

Instead, deductions lower the amount of your taxable income. Depending on which tax bracket you fall into, you could save more or less on a deduction than someone with a higher or lower income.

To determine the impact a deduction might have on how much you owe, you multiply the amount of your deduction by your tax bracket. For instance, if you have a $6,000 deduction and are in the 10 percent tax bracket, you’d pay $600 less in taxes.

Why deductions are important

Designed to offset how much you owe on taxes, a deduction applies when you pay for expenses like tuition, healthcare, retirement contributions, and any self-employment gains or loses you had throughout the year.

Before you gather up all your receipts, know that you should only take these types of itemized deductions if your total amount is greater than the standard deduction you get automatically. In 2018, the standard deduction was $12,000 for individuals, which means you’ll only benefit from tax deductions if you paid more than this amount.

How to spot deductions

The most common tax deduction is the amount of interest you pay on a home mortgage loan. As previously mentioned, deductions don’t reduce your tax bill dollar-for-dollar, but they do lower your taxable income which, in turn, will decrease the amount you owe.

Generally, deductions don’t provide a benefit unless you’re spending an enormous amount in qualifying expense. They’re only beneficial if your costs go above the standard deduction amount, which isn’t a common occurrence for most.

What are adjustments?

Adjustments are another category of tax “write-offs” that reduce your total, or gross income. Though they’re used to lower your overall tax liability, you don’t go through the complicated and time-consuming process of itemizing them. Instead, adjustments are directly deducted from your gross income and are used to arrive at your Adjusted Gross Income (AGI).

Why they’re important

Your AGI is an important factor, perhaps even more critical than your taxable income, since it determines the different deductions and credits for which you’re eligible. Understanding how adjustments impact your income helps to reduce the amount of taxable income that you report on your tax return.

As more adjustments are subtracted from your income, your AGI becomes a lower amount, too. Even though adjustments don’t directly impact the amount of taxes you owe, it does change your AGI. Since that’s what is used to determine your tax bracket and the percentage of income tax you pay, a lower AGI means a lower tax bill, too.

How to spot adjustments

It might come as a surprise to you that the standard “Student Loan Interest Deduction” is a tax adjustment and not a deduction at all. The amount you pay in student loan interest is used to adjust your gross income to arrive at your AGI.

Other common adjustments include:

  • alimony payments made to a former spouse (for agreements made before 2019)
  • IRA contributions
  • If you’re self-employed, half of the self-employment taxes you pay

When spotting adjustments, it’s essential to use the right tax form. The 1040 is the only one that lets you take advantage of deducting every possible adjustment. Filing using the 1040A severely limits the number of adjustments you can make, and form 1040EZ doesn’t allow any adjustments to income and calculates your AGI as the same as your total income.

The best tax software to help you do your taxes

Luckily, most tax software can help you determine your adjustments, tax credits, and deductions. Here’s a comparison of what we believe are the five best tax softwares:

 
TurboTax
Liberty Tax Online
H&R Block
TaxAct
E-File
Free Version?
For simple tax returns
Not offered
For simple tax returns
For simple tax returns
For simple tax returns
Other Plans
Deluxe: $39.99
Premier: $59.99
Self-employed: $89.99
Basic: $34.95
Deluxe: $54.95
Premium: $79.95
Deluxe: $22.49
Premium: $37.49
Self-Employed: $59.99
Basic: $11.96
Deluxe+: $30.95
Premier+: $46.36
Basic: Free
Deluxe: $24.95
Premium: $34.95
Import Return from Competitor
Yes, by PDF
Yes
Yes
Yes, from TurboTax & H&R Block
N/A
Customer Support
24/7 Live Support
Chat & email
Live chat & phone support
Email or phone
Email
Business Features
QuickBooks interface
Create W2s & 1099s
Separate plan to prepare business returns for partnerships
N/A
Create W2 & 1099 forms
File employer tax returns
Prepare Forms 1065 (Partnerships)
1120 (C Corps)
1120S (S Corps)
N/A
Refund Tracking
Yes
Yes
Yes
Yes
N/A
Audit Assistance
Free Guidance + Premium Representation ($44.99)
Assistance only
no direct representation
Free in-person audit support
Assistance only
no direct representation
Direct representation at no extra charge
Learn More

Summary

When calculating the amount you owe for taxes, keep in mind there are weighty differences between deductions, credits, and adjustments. Taking the time to understand their differences and how they work together will significantly reduce your overall tax bill.

If you’re overwhelmed by all this information, your best bet is to use a tax preparer, or a tax software that can help determine your credits, deductions, and adjustments for you.

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About Aja McClanahan

Aja McClanahan is a best-selling author, blogger, and writer who covers personal finance and entrepreneurship. Her family's personal story of getting out of over $120,000 in debt has been featured in places like Yahoo! Finance, Kiplinger's, MarketWatch, U.S. News and World Report. She also writes regularly at her website, Principles of Increase, on topics related to money and business. You can connect with her on Twitter.

Comments

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  1. Robert says:

    Well done! This article could help out so many people. I know this to be true, because it certainly helped me put these “write offs” into a clear picture.

  2. paul says:

    hi..
    This is nice blog and information so continue work best of luck

  3. Nick says:

    good post! I think a lot of people, even those that think they know everything about taxes, can benefit from a refresher like this.

  4. Darla Serrano says:

    This was a really great post. I’m glad you put into simple words what the differences are between all the “write-offs”! I’m always helping people that try to make financial decisions solely on the tax implications. They seem to think their expense will be a direct reduction of what they pay in taxes and that’s just not case most of the time. I think there is a lot of confusion on how write offs work and what their roles are in your overall financial plan.

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