Both tax credits and deductions reduce your tax bill. Deductions reduce your income, which in turn reduces your taxes. Credits directly reduce the taxes that you owe. Understanding the differences between them can help you make sure you’re paying the least amount of tax. Please consult current IRS regulations and your tax professional to make sure you are using the most current standards.
Tax credits reduce the taxes you pay. Said a little differently, a tax credit reduces your tax bill dollar-for-dollar. This means that after you’ve calculated your taxes these credits reduce the final amount you owe. These are less common than deductions as there are more income limitations and may be more complicated to determine.
Tax deductions reduce the amount of income prior to tax being assessed. A tax deduction reduces your income dollar-for-dollar. You subtract the deductions from your income to determine your Taxable Income.
The value of a tax deduction depends on your tax rate. If you have a higher marginal tax rate, then you benefit more from a deduction. For example, if you have a $5,000 deduction with a 22% Marginal Tax Rate, the deduction would reduce your taxes by $1,100. However, if you are in the top tax bracket of 37%, then the deduction would reduce your taxes by $1,850.
Comparison of Credits vs. Deductions
Tax Credits for High-Income Earners
There are many income exclusions that apply to tax credits that limit the ability of high-income earners to use them. There are few general categories of tax credits: children, education, and big-ticket “green”.
- Child Tax Credit – If you earn less than $400,000 married filing jointly, you may qualify for reducing your taxes owed by $2,000 per child.
- Residential Energy Tax Credit – If you are considering solar panels, solar-powered water heaters, wind turbines, geothermal heat pumps, or other renewable energy equipment, this credit may allow you to tax a portion of your costs and reduce your taxes.
- Plug-in Electric-Drive Motor Vehicle Credit – A new (sorry used doesn’t count) plug-in electric vehicle may allow you to reduce your taxes by a minimum of $2,500 and up to $7,500. The battery capacity and vehicle weight rating help determine the value of the credit.
Tax Deductions for High-Income Earners
Above the Adjusted Gross Income (AGI) Line
- Health Savings Account (HSA) Contributions – HSAs are an amazing account. Contributions are tax-deductible, the money grows tax-free, and withdrawals are tax-free for qualified medical expenses and for those over 65 years old for any spending purpose.
- Qualified Retirement Plan Contributions – This is the amount you contribute to your work’s qualified retirement plan (401(k), 403(b), 457…). These reductions come directly from your paycheck. Some plans now offer Roth contributions which would not be a deduction.
- Qualified Charitable Distributions (QCD) – A qualified charitable distribution is an IRA distribution that is paid directly from the IRA to a qualified charity by an individual 70.5 years of age or older. The IRS lets you donate from your IRA tax-free to the charity. This is a huge savings if you are charitably inclined.
Below the Adjusted Gross Income (AGI) Line
- Standard Deduction – The Tax Cut and Jobs Act (TCJA) significantly increased the Standard Deduction. It is much harder for high-income earners to itemize particularly because of the $10,000 cap on State & Local Taxes. The majority of taxpayers are now using the standard deduction. For 2021, the standard deduction is $12,550 for single taxpayers and $25,100 for married filing jointly.
If the following items are high you may want to consider itemizing your deductions on Schedule A rather than using the standard deduction:
- Charitable Contributions – Donations to charitable organizations are a great way to reduce your tax burden. These are all of your donations excluding any Qualified Charitable Donations. A few strategies to consider: donate low cost basis stock, use a donor-advised fund, or lumping charitable donations in a single year.
- Mortgage Interest Expenses – The interest on your mortgage may be tax-deductible.
- State and Local Taxes (SALT) – The total of your taxes paid to state and local governments can be deducted up to $10,000. Beyond income taxes, local government taxes can include real estate taxes and personal property taxes (cars, boats…).
Tax credits and deductions work differently. Both of them can chip away at the taxes you owe. By understanding both, you can help maximize their value and lower the amount of taxes you pay. Determining what deductions and credits apply to you can be difficult. Consider consulting a tax professional that can help determine what would apply to your situation.