When filing taxes, two of the most powerful tools are credits and deductions. Deductions shrink the income that gets taxed, while credits directly reduce the tax you owe. Together, they decide how much of your hard-earned money stays with you once your return is complete.
Credits and Deductions Explained
During tax preparation, individuals and small businesses can save money by claiming tax credits and deductions. Tax credits reduce the tax you owe directly, dollar-for-dollar. In contrast, a deduction lowers the taxable income on which taxes are calculated. The benefit of a deduction depends on the taxpayer’s bracket.
How Tax Deductions Work
A tax deduction reduces the amount of income that is taxed. This means taxpayers subtract allowed expenses from their gross income before calculating their tax. For example, if a small business has $100,000 in revenue and $20,000 in deductible expenses, the taxable income becomes $80,000.
Taxpayers may take the standard deduction or itemize expenses like mortgage interest, state taxes, and charitable donations. Every deduction lowers taxable income, which indirectly cuts the final tax. The actual tax savings equal the deduction times the tax rate.
Common tax deductions include:
- Standard Deduction: A fixed deduction amount for eligible filers, reducing taxable income.
- Retirement Contributions: Contributions to IRAsor 401(k) plans that reduce taxable income.
- Home Mortgage Interest: Deductible interest on a home loan if the taxpayer itemizes.
- Charitable Donations: Gifts to qualified charities can reduce taxable income when itemized.
- Business Expenses: Valid costs of running a business (such as office supplies, equipment, and travel) can be deducted by businesses.
How Tax Credits Work
A tax credit subtracts directly from the tax owed. This provides a dollar-for-dollar reduction in the final tax bill. For example, a $1,000 tax credit cuts the tax owed by $1,000. This direct reduction makes credits very valuable.
Tax credits can be refundable or non-refundable. A refundable credit can generate a refund even if it exceeds the tax due. For example, the Earned Income Tax Credit is refundable for low-income workers, while many credits are non-refundable. The Child Tax Credit, for instance, is partially refundable and subject to income limits.
Common tax credits include:
- Child Tax Credit: A credit for taxpayers with eligible dependent children.
- Earned Income Tax Credit (EITC): A refundable credit for low- to moderate-income workers.
- Education Credits: Such as credits for qualified tuition expenses (e.g., the American Opportunity Credit).
- Research & Development (R&D) Credit: For businesses investing in research and development.
- Work Opportunity Tax Credit: For businesses that hire employees from certain target groups.
- Energy Efficiency Credits: For qualifying energy-saving home improvements or business equipment.
Using Both for Maximum Benefit
Taxpayers can claim credits and deductions (but not for the same expense) to reduce taxes. For instance, a taxpayer might deduct a charitable gift and also claim the Child Tax Credit, while a business owner could deduct home office costs and use the R&D credit.
Credits usually save more because they cut the tax bill directly, while deductions lower taxable income. Use deductions first, then apply credits to reduce the final tax due. This combination can lead to a bigger refund or smaller balance owed.
Exquisite Tax Service Offers Expert Tax and Financial Solutions
At Exquisite Tax Service, we provide personal and small business tax accounting services in North Richland Hills, TX, to support individuals and local entrepreneurs. Along with expert tax consulting for complex filings, we also offer professional notary services for added convenience. Clients rely on our tax preparation service in North Richland Hills, TX, to identify every available credit and deduction.
Contact Exquisite Tax Service today to schedule your consultation and let our local experts handle your tax needs!