Credits and Deductions

Understanding the Difference

Added 8/25/05

 It seems that the average taxpayer does not understand the difference between a credit and a deduction.

 A credit is deducted from the tax owed, while a deduction is deducted from income before the tax is calculated. Most deductions are “itemized”, while a few are “above the line”.  For now, just be aware that “above the line deductions” are more favorable than “itemized” deductions. 

Credits are further split into:  Refundable and non-refundable.  A refundable credit will be paid to you in cash.  This is over and above the amount of any regular refund generated by too much withholding.  A non-refundable credit can only reduce your tax to zero.

 Some of the more obvious deductions are:

• Donations to charities.

• Real Estate taxes paid.

• State & Local income taxes paid.

• State & Local sales taxes paid.

• Medical expenses (including the cost of health insurance) paid.

• Gambling losses up to the amount of gambling winnings.

• Non-reimbursed job expenses.

• Moving expenses paid for moving to a new job (above the line).

• Home mortgage interest paid.

• Student Loan interest paid (above the line).

• Higher education expenses up to $4,000 (above the line).

• IRA payments (above the line).

A not so obvious “above the line” deduction is $2,000 for the purchase of an approved hybrid car (gas & electric engine automobile).  The latest approved model is the 2006 Toyota Highlander.  Some other qualifying cars are the Prius and some Ford models.  A new hybrid car purchased in 2006 will only get you a $500 deduction.

 Some of the more obvious non-refundable credits are:

• Hope & Lifetime Learning credits.

• Child Dependent Care Credit.

• Adoption Credit.  Any amount of adoption credit that is not used in one year may be carried forward to future tax years.

 Some of the less obvious non-refundable credits are:

• Retirement credit (available only to persons that receive no social security)

• Investment Tax Credit (from business entities).  Any credit not used in the current year may be carried forward for 20 years.

• Retirement Savings Contributions Credit – available only to joint filers with incomes below $50,000 or single persons with incomes below $25,000.

• Foreign Tax Credit.  Any amount not used in the current year may be carried forward for 10 years or until fully used.

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Some of the more obvious refundable credits are:

• Child Tax Credit for dependent children under the age of 17.

• Earned Income Credit

There are two not so obvious refundable credits:

• Credit for off-road business use of gasoline or diesel fuel.

• Credit for taxes paid by a mutual fund on long term capital gains.

As a general rule, credits are of more value than deductions, especially if you are in the 15% tax bracket.  In some cases, the higher education “above the line” expense of $4,000 results in less tax than the Hope or Learning Tax Credits – especially for joint taxpayers with incomes over $100,000.

In any event, be sure to remember that there is a world of difference between a tax deduction and a tax credit and that an “above the line” deduction is much more favorable than an “itemized” deduction.