Updated: Feb 26, 2020
There are several different types of credits and deductions that a qualified taxpayer can claim. They are mutually exclusive and requires different qualifications in order to be claimed. Which makes it imperative to know the underlining difference between the two.
• A credit reduces the taxpayers tax liability and/or increases their refund
• A deduction simply decreases the taxpayer’s taxable income
To be qualified for most credits and deductions, it requires taxpayers to meet certain income threshold as well as other qualifying factors. Some credits and deductions are more well-known than others, of which a few popular ones will be discussed below.
• Earned Income Tax Credit (EITC). This may very well be the most rewarding credit that is designed for low to moderate income taxpayers, because it is fully refundable. It has a maximum refundable value of $5,667, for a taxpayer who has three or more qualifying dependent with income of up to $50,162 ($55,952 joint filers). However, once the taxpayer’s income begins to surpass the threshold the credit then begins to phase out (decrease) until it reaches zero. Another caviar to this credit requires the taxpayer not to have investment income of more than $3,600.
• Child Tax Credit (CTC) & Credit for Other Dependent (ODC). Only taxpayers with a qualified child or dependent can claim either of these credits. Eligibility is determined by the child/dependent’s age, relationship, residency, and the level of support given by the taxpayer. The taxpayer claiming these credits must be able to substantiate each qualifying category. For example, they must be able to prove their relationship with the child/dependent.
Child Tax Credit (CTC): To claim this credit the child must be under age 17 and resided with the taxpayer, who provided more than half of the child’s living needs. The CTC is worth a maximum of $2,000, of which up to $1,400 is refundable.
Credit for Other Dependent (ODC): The major differentiator between the ODC and the CTC is the age test. Once the qualifying depended reaches age 17 as of December 31, the CTC can no longer be claimed for that child. Therefore, the next qualifying option would be the ODC. The ODC is nonrefundable and is worth up to $500 per qualifying dependent. For example, claiming an elderly parent or disabled loved one.
• Savers Credit. Taxpayers who may have contributed funds into their retirement accounts (i.e. 401K, IRA) may be eligible to claim this credit. This credit is determined by the taxpayers filing status and adjusted gross income (AGI). However, if the taxpayer is a full-time student, under the age of 18, or can be claimed as a dependent they are ineligible to claim this credit. The saver credit is nonrefundable with a maximum value of $1,000, $400, and $200 based on the taxpayer’s filing status and AGI.
• Foreign Tax Credit. Taxpayers who were subject to foreign tax withholding may be eligible to claim this credit. When a taxpayer pays foreign taxes, they can choose between the tax credit or the tax deduction (itemized on Schedule A), however, the credit is often more advantageous for the average taxpayer. This credit is nonrefundable and is determined by the foreign taxes that were assessed, of which the maximum credit value for a single person is $3,000 ($6,000 joint filers).
• American Opportunity Tax Credit (AOTC) & Lifetime Learning Credit (LLC)
AOTC allows students, the parent of the student, or the spouse of the student to be able to claim a partial refundable credit. The maximum amount that this credit is worth is $2,500, of which only up to $1,000 (40%) is refundable. This credit can only be claimed four times throughout the duration of the student’s higher education enrollment. However, the student can be deemed ineligible to claim this credit if they have a felony conviction drug record as of the last day of the year (12/31).
LLC if often claimed by those who may not be eligible to claim the AOTC. Compared to the AOTC, the Lifetime Learning credit does not have a limit on the number of times it can be claimed. It is a nonrefundable credit worth up to $2,000. This credit is most enticing for graduate students and those pursuing professional studies.
• Home office Deduction. Taxpayers who uses a part of their home exclusively and regularly for business can deduct a portion of the expenses associated with running the business out of their home. When claiming this deduction, the taxpayer has two methods to choose from. These are the simplified option or the regular method (actual expenses).
Simplified option: This is determined by square footage of space being used and the predetermined standard rate given by the IRS. The taxpayer is only allowed to deduct a maximum of 300 square feet, which is then multiplied by the standard rate of $5 (per square footage). For example, if a taxpayer uses a space in their home for business that only occupies 250 square feet, then their total deduction would be $1,250 (250*5).
Regular Method (Actual Expense): Allows taxpayers to deduct the actual expenses associated with the home office both directly and indirectly. Which includes a repair that was done to the space (direct), or a percentage of the mortgage interest paid on the home (indirect). This is configured by a percentage derived from calculating the square footage of the home being used for business. For example, if the total square footage of the home was 2,000 and only 300 square feet of the space was being used for business the percentage of expenses deductible would be 15% (300/2,000). For instance, if rent was $1,000 and monthly utilities were $150 the total home office deduction for the year would be $2,070 [(.15*1000) + (.15*150) *12]. However, claiming this option means that the taxpayer would have to maintain adequate records to substantiate the expenses being claimed.
• Itemized Deduction. These are expenses that were incurred by the taxpayer throughout the year. Though there are several types of expenses that can be itemized, it does not include everyday expenses. For any expense to be itemized there must be proof to substantiate the claims being made. Some example of expenses that can be itemized are medical and dental expenses (non-cosmetic), state and local taxes or sales tax, personal property taxes, real estate taxes, mortgage interest expense, charitable contribution, etc. For a deeper read of itemized deduction visit our earlier blog post “Standard Deduction vs Itemized Deduction”.
• Student Interest Loan. This is an education tax break that allow students who began repaying their loans which were incurred from attending a qualified higher education institution. Qualified taxpayers can deduct up to $2,500 of their interest paid, however, if the filing status of the taxpayer is married filing separate, they are ineligible to claim this deduction. Additionally, if the taxpayers Modified Adjusted Gross Income (MAGI) surpasses $70,000 (if single) the deduction then begins to phaseout until it can no longer be claimed.
• Work-Related Education Expenses. Taxpayers can take this deduction if they meet certain qualification, which includes proving that the expenses were to maintain or improve their present skillset. Additionally, the taxpayer must have attended school to become recertified or was required by their employer to keep their salary, job status, or position. On the other hand, if the taxpayer attended an institution to gain new skills, they are ineligible to claim this credit.
• Teacher Education Expense. This deduction allows teachers to claim a maximum of $250 ($500 joint filers) in education expenses that was not reimbursed by their employer. Qualified expenses include materials and supplies purchased for classroom usage to enhance the learning experience.
Tax credits and deductions are often overlooked due to taxpayer’s lack of knowledge and tax preparer’s not being edifying. Though some credits and deductions may not be as impactful as others, it still allows the taxpayer to obtain some sort of saving. Nevertheless, it is critical that taxpayers know the difference between credits and deductions, because they are mutually exclusive. Qualifying for either a credit or deduction requires some form of tax planning.