Britannica Money (2024)

Tax season. Perhaps it should be called “tax-confusion” season.

For example, you’ve probably heard people talk about their tax deductions and tax credits. But what’s the difference, and which one is better? And then there are refunds. Some of your friends may get a big refund, while others have to pay on April 15. Why? And is it better to get a big refund, or is it really just an interest-free loan to Uncle Sam?

Here are things you need to know about tax deductions, tax credits, and tax refunds.

What are tax deductions?

Tax deductions are amounts that you subtract from your income before calculating your federal taxes. On the first page of your tax return Form 1040, you start by listing your wages and other income. Further down the page, you’re allowed to take deductions, which will reduce your gross taxable income.

The majority of taxpayers will take the standard deduction, which is a specific amount determined by the IRS each year. It depends on your filing status (single, married, or so-called “head of household”).

But if the total amount of your qualified deductions—mortgage interest, state and local taxes, and charitable donations, for example—is above a certain threshold, you’ll want to itemize deductions.

What is a tax credit?

Tax credits reduce the amount of tax you owe. Taxes are calculated first, then credits are applied to the taxes you have to pay. Some credits—called refundable credits—will even give you a refund if you don’t owe any tax.

Other credits are nonrefundable, meaning that if you don’t owe any federal taxes, you don’t get the credit. Or, if you owe $1,000 in taxes, but qualify for a $2,000 tax credit, you can only claim a credit for the $1,000 you owe.

Some nonrefundable tax credits will allow you to carry forward any unclaimed amount. So if you owe taxes the next year, you can claim more of that $2,000 credit.

Tax credits vs. tax deductions: A comparison

As a reminder, tax deductions are “top-line,” meaning they’re deducted from your income before your taxes are calculated. Tax credits, on the other hand, are “bottom-line”—after your taxes are calculated, a tax credit is deducted, dollar for dollar, from the amount you owe. Tax credits, therefore, give you a lot more bang for the buck.

For example, let’s take two taxpayers, Andrew and Brenda. Suppose they each have the same income of $100,000, and the same effective tax rate (after consulting the marginal tax rate tables) of 18%. Brenda took the standard deduction of $12,950, but she’s owed $4,000 in tax credits. Andrew, meanwhile, had $4,000 in itemized deductions over and above the standard deduction, but he didn’t qualify for any tax credits.

In other words, Andrew and Brenda have the same tax profile, but Andrew has an extra $4,000 in tax deductions while Brenda has an extra $4,000 in tax credits. See the table below.

Brenda’s $4,000 tax credit resulted in a final tax bill that was $3,280 less than Andrew’s. Deductions are great. Credits are even better.

What is a tax refund?

If you earn income from an employer, money is taken out of your paycheck for federal taxes (among other things) each pay period. If you’re an independent contractor or are self-employed, you’ll likely make quarterly tax payments. These periodic tax assessments are simply estimates; the actual amount you owe in a year’s time depends on your family situation, your filing status, and the number of deductions and credits you ultimately qualify for.

When you gather your tax information and fill out Form 1040, your actual tax assessment will be calculated (by your tax preparer or tax software you use) based on your income minus deductions, adjustments, and tax credits for which you qualify.

If you’ve paid more throughout the year than you owe, you’ll get a refund. If you haven’t paid enough, you’ll owe the balance on Tax Day.

The bottom line

Many people think the goal is to get a big refund. You might even see ads for tax services promising the “biggest refund.” But unless you have surprise tax credits or refundable tax credits, getting a refund may not be the best way to plan your financial strategy.

Remember: As you pay taxes all year, that money comes out of your paycheck and goes to the U.S. government. You don’t get any overpayment back until spring of the following year (or later, depending on when the IRS processes your refund). And, no, the government doesn’t pay you interest. Is it really better to “save” for a big splurge or purchase by overpaying taxes all year and getting that big refund? Or is it better to pay less all year and use the cash or save it over time?

The answer, of course, depends on your level of discipline. If you can trust yourself to keep your hands off your savings, you’re much better off padding your emergency fund or letting it compound in an interest-bearing account.

When you do your taxes, there’s usually a tax planning section at the end of the software. If you use a professional service, your tax preparer might suggest an annual tax planning meeting. Although you may just be glad to get those taxes done, go ahead and spend some time planning for next year. If you can pay only what you owe in taxes during the year, you’ll be happy knowing that, throughout the year, your money was working for your benefit, not for Uncle Sam’s.

References

• Credits and Deductions for Individuals | irs.gov