People often use the terms “tax credit” and “tax deduction” interchangeably. But are they the same, really? And if not, is one better than the other, or does that depend on the situation?
To answer the first question, no—a tax credit is not the same as a tax deduction. A tax credit lowers your tax bill dollar for dollar, while a tax deduction lowers your taxable income. So what does that really mean?
Let’s say you receive a $1,000 tax credit. You’ll simply pay $1,000 less in taxes, regardless of your tax bracket. A $1,000 tax deduction on the other hand, is dependent on your tax bracket. If you’re in the 25% tax bracket, a $1,000 tax deduction will lower your tax bill by $250 (25% of $1000). Tax deductions are typically given in higher tax brackets. Clearly, you’ll save more money with a tax credit. (You can’t claim a tax credit and a tax deduction on the same item, for those who were wondering.)
Pretty straightforward, right?
Unfortunately, not exactly. Our current tax system is—well, a convoluted mess that only helps tax accountants and lawyers. The first time the tax code was published in 1913, it was a “mere” 400 pages. As of 2011 it has ballooned to 72,536 pages.
Needless to say, it’d be pretty impossible to understand, much less follow the entire thing. And that’s where the problem comes in.
Recall, what we talked about earlier—a tax credit will save you more money than a tax deduction.
So what does this have to do with the tax code being over seventy-two thousand pages long? Let’s take a look at the American Opportunity tax credit…
The American Opportunity tax credit, which recently replaced the Hope tax credit, can reduce your taxes by up to $2,500 on the first $4,000 of qualifying educational expenses. This means that you can receive a tax credit on 100% of the first $2,000 of qualifying expenses, and 25% of the next $2,000. The income cutoff for the tax credit is $180,000 for those married filing jointly, and $90,000 for those filing single. Okay, so there’s nothing odd about that.
So let’s move on to the Tuition and fees deduction. You can deduct up to $4,000 in qualified educational expenses if you’re married filing jointly, and your income is not more than $130,000, or $65,000 if you’re filing single. If your income is more than $130,000 ($65,000 filing single), but not more than $160,000 ($80,000 filing single), you can deduct up to $2,000 of qualifying educational expenses.
But wait. Aren’t deductions generally supposed to be for those in higher tax brackets?So why isn’t that the case here, if your income is between $130,000 ($65,000 single) and $160,000 ($80,000 single)?
Remember when I said that the American Opportunity tax credit replaced the Hope tax credit? The American Opportunity tax credit has higher income limits than the Hope tax credit did, but the income limits were not increased on the Tuition and Fees deduction. So here’s a case where a tax credit and a tax deduction overlap.
And that’s the problem lots of taxpayers are running into with our current tax code. It doesn’t follow the rules, and in many cases it doesn’t make a whole lot of sense. It’s easy to see why many people don’t take advantage of as many tax credits and deductions as they could.
Is there a solution to this? In short, yes…but that’s a whole other post. Stay tuned!
