The short version
- Tax credits lower the amount of tax you owe while tax deductions lower your taxable income.
- Which credit or deduction you can apply to your taxes depends on things like your income level, if you have kids, and your type of expenses in the year, such as medical expenses, donations and mortgage interest.
- There are some investments that can also offset your tax bill, like a 401(k), real estate, or a 529.
Tax credits vs. tax deductions
The concept of a tax credit and a tax deduction can be confusing because they sound similar. However, they are different: Tax deductions lower your taxable income, while tax credits lower the amount of tax you owe.
For example, a tax deduction might lower your taxable income from $60,000 to $50,000. A tax credit would directly reduce the amount of tax you owe (your tax bill) on the remaining $50,000.
Tax credits are highly desirable because they directly reduce your tax bill. Here are some examples of tax credits:
Child tax credit (CTC): The CTC is available to taxpayers with children that qualify as dependents. In 2021, this credit was increased from previous years to $3,600 per qualifying dependent (for children ages 5 and under) and $3,000 (for children ages 6 through 17). In 2023, the credit has been decreased back to $2,000 per dependent under the age of 17 for the 2022 tax year. To be eligible for the CTC, you must have an individual income of less than or equal to $200,000 or a combined income of $400,000 or less for joint returns.
Electric vehicle: Some states, such as California, have electric vehicle tax credits. The federal government provides a tax credit of up to $7,500 for qualified plug-in electric vehicles as well.
Earned income tax credit (EITC): The EITC is designed to lighten the tax burden of low- to moderate-income workers and families. Eligibility is based on family size and income. This credit ranges from between $560 (for filers with no qualifying children) and $6,935 (for filers with three or more qualifying children).
Tax filers are given the choice to either take the standard deduction or itemize deductions on their tax return.
Standard deductions: For the 2023 tax year (2022 returns), the standard deduction is $13,850 for single filers and $27,700 for joint filers.
Itemized deductions: Itemizing your deductions allows you to claim qualified deductions individually. There are numerous tax deductions you can benefit from, such as medical expenses, donations and mortgage interest, etc.
Investments that offset your tax bill
The federal government offers incentives for saving and investing through a number of tax-advantaged accounts, as well as ways to offset your capital gains tax liability. Here are some investments that can potentially save you tax dollars:
401(k): Contributions made to a tax-advantaged retirement account — like an employer-sponsored 401(k) — can reduce your income tax. Money contributed to your 401(k) is usually pre-tax and you will not pay taxes until you begin making withdrawals.
Individual retirement account (IRA): A traditional IRA offers an individual to contribute pre-tax income, while a Roth IRA is contributed using post-tax income. Contributions to traditional IRAs are taxed when withdrawals are made in retirement; Roth IRA contributions are usually tax-free upon withdrawal in retirement. These accounts do not need to be sponsored by an employer but are subject to income limitations.
Real estate: You can qualify for an exemption on capital gains taxes on the sale of your primary personal residence. This is allowed every two years, provided that you have lived in your primary residence for two of the last five years prior to its sale date.
More: Rental property tax deductions: everything you need to know
529 plan: You can save for your child or grandchild’s education by investing in a 529 plan. Capital gains made within the account will not be subject to federal taxes if they are withdrawn for qualified educational expenses. However, a 529 does not offset your income tax and money put into the account is post-tax. Details vary by state.
An example of how you can lower your taxes
Here’s an example of how you can lower your income tax by investing in a 401(k). Say you contribute 5% of your annual salary of $100,000 to your 401(k) each year. That $5,000 of pre-tax contribution is invested, and lowers your taxable income to $95,000.
Another tax offset strategy is realizing capital losses. For example, if you realize a capital gain of $5,000 from ABCD stock and a capital loss of $3,000 from WXYZ stock, you will only have to pay capital gains tax on $2,000 of ABC stock. This strategy is called tax loss harvesting. You can generally use up to $3,000 of capital losses to offset your ordinary income each year if you have no capital gains to offset.
More: How to claim a stock loss on taxes
Personal deductions that can lower your tax bill
There are many personal deductions a taxpayer can make to lower their tax liability. First, let’s compare using a standard deduction versus an itemized deduction.
Itemized vs. standard deductions
You can choose to take a standard deduction or itemize your tax return, but you can’t do both. Generally, whichever approach yields the higher deduction is the one chosen.
The standard deduction is a very simple approach. For 2023, the standard deduction for single taxpayers and married individuals filing separately is $13,850 and $27,700 for married couples filing a joint tax return.
Choosing the itemized deduction approach takes more time, requires knowledge of individual deductions, as well as proof such as receipts. You must keep track of all of your qualifying expenses throughout the year. You should consider itemized deductions if the amount exceeds a standard deduction. For example, if you have a mortgage, you may want to consider using an itemized deduction because you can claim the mortgage interest deduction.
Utilizing the many itemized deductions may feel overwhelming for some. You can also hire a tax expert such as a CPA to help you as they are more knowledgeable about what can and can’t be used as an itemized deduction. Some tax software services, such as TurboTax, also offer access to CPAs and other experts.
Some common itemized deductions include:
Mortgage interest: Home mortgage interest is deductible on the first $750,000 in loans.
Real estate taxes: You can deduct your state and local property tax. This deduction is limited to a combined total of $10,000, or $5,000 if you are married and filing separately.
Unreimbursed medical/dental expenses: You may be able to deduct out-of-pocket medical and/or dental expenses that are not covered by insurance if those expenses exceed 7.5% of your adjusted gross income.
Charitable donations: Donations made to qualified charities could be deductible but can’t exceed 60% of the taxpayer's adjusted gross income.
The bottom line
Knowing about tax deductions and tax credits is beneficial when doing your taxes, but this knowledge will go even further if you plan financial decisions with taxes in mind. For example, if you’re in the market for a new car, check to see if your state offers electric vehicle tax credits. Or if you’re having a poor year in the stock market, consider cutting some of your losses strategically in order to offset capital gains.
If all of this sounds too complicated and timing consuming, you can also consider hiring a tax professional. Unsure about where to file taxes? You can find out more in our best tax software for investors guide.
Regardless of whether you hire a professional, you’ll want to make sure you maximize your tax credits and tax deductions. Who knows, you may even be able to get a tax refund!
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided “as is” without any representations or warranties, express or implied.