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“My friend got a nice refund, why can’t I get the same amount?”

This is what a client asked me one day.

She did not realize that her friend went to school and worked. Plus she was paying for school out of pocket. And so she maximized her American Opportunity Credit (AOC). AOC is a refundable tax credit the government gives to undergraduates who paid tuition out of pocket or through a loan.

On the other hand, the client was single, a W2 employee, wasn’t in school, and did not donate to charity that year. Thus, she didn’t qualify for a tax credit like AOC.

Tax credits and tax deductions are given to taxpayers to help offset their tax liabilities. The tax credit or deduction you qualify for will be different depending on who you are.

What is a tax credit?

According to the IRS, “A tax credit is a dollar-for-dollar amount taxpayers claim on their tax return to reduce the income tax they owe. Eligible taxpayers can use them to reduce their tax bill and potentially increase their refund”.

Tax credits are deducted directly from your tax liability.

This means, if you owe the IRS $5000, and you receive an eligible tax credit of $2000, your tax liability will reduce to $3000. If your tax credits climb above your tax liability, you will receive a refund.

There are two kinds of tax credits: refundable and non-refundable credits.

A refundable credit is a tax credit that not only reduces how much you owe in taxes but it can result in the government giving you extra money. If the credit offsets how much you owe, you will receive a refund.

Apart from the AOC I mentioned earlier, other refundable tax credits include earned income credit, additional child tax credit, premium tax credit, and dependent care credit.

A non-refundable tax credit on the other hand means you receive a refund up to the amount of your tax liability so if a taxpayer paid $1000 in taxes, that will qualify them to receive the refundable credit of $1000. You don’t get anything extra. In other words, this type of credit can only reduce the tax liability to zero, and any excess amount that cannot be used is lost.

Examples of refundable tax credits are residential energy credit, lifetime learning credit, adoption credit, and foreign tax credit.

What is a tax deduction?

A tax deduction reduces the amount of income that is subject to taxation. It can reduce your taxable income, which in turn, can reduce your overall tax liability. Deductions are generally based on eligible expenses, and the actual tax savings depend on the taxpayer’s tax bracket.

Based on this definition, if Mr. X originally owed the IRS $1200, but based on eligible expenses and his tax bracket, he qualifies for a $1000 deduction, Mr. X will only owe $200.

The government gives every taxpayer a standard deduction based on filing status (e.g. single, married filing jointly, married filing separately, etc) and in some cases age.

Some people may qualify for itemized deductions because they’re allowable deductions exceed their standard deductions. Examples of deductions that may qualify individuals for itemized deductions are medical expenses, state and local taxes, real estate taxes, charity giving, and mortgage interest deductions.

Tax deductions and tax credits are different, but the US government provides both of them to help reduce the tax burden on taxpayers.

Need a reliable tax professional to handle your individual or business taxes? Call Nonterah Financial Services TODAY at 858-769-9212.