When you are calculating your federal income tax, there are two broad categories of items that commonly help taxpayers reduce the amount of tax they owe. These two items are itemized deductions and tax credits. But there is often confusion about the difference between itemized deductions and tax credits and what makes one of these categories better than the other when it comes to reducing the amount of tax that a taxpayer owes.
An itemized deduction is an amount a taxpayer can include in their federal income tax return that will help decrease their taxable income by a percentage equal to the income tax rate the taxpayer is paying. Taxpayers are allowed to take either a standard deduction or their itemized deductions, whichever is greater. Determining which is greater will obviously vary from taxpayer to taxpayer, depending simply on if a given taxpayer has enough expenses that qualify as itemized deductions such that the total amount of itemized deductions exceeds the amount of their standard deduction.
Itemized deductions commonly include but may not be limited to amounts paid for medical expenses, state and other taxes, mortgage interest, and charitable contributions.
A tax credit is an amount a taxpayer can include in their federal income tax return that will help decrease the amount of actual tax owed dollar for dollar. Common tax credits include but may not be limited to earned income credits, credits for the elderly, mortgage interest credits, child credits, and credits for energy improvements.
We can consider an example using itemized deductions (rather than the standard deduction) and tax credits to help make the difference between these two categories clearer.
We will use the following dollar amounts for purposes of this example:
Income – $10,000
Itemized Deductions – $2,000
Effective Tax Rate – 25%
Tax Credits – $2,000
Federal income tax is basically calculated as follows:
(Income – Itemized Deductions ) x Effective Tax Rate – Tax Credits = Federal Income Tax
Using the dollar amounts noted above, when we plug them into the tax calculation, we come up with the following:
($10,000 – $2,000) x 25% – $2,000 = $0
Even though few of us are likely to be so blessed as to owe no taxes, even so, we can still use this example to under the impact of itemized deductions and tax credits (and which is better).
If a taxpayer has $10,000 in income and is paying an effective tax rate of 25%, the taxpayer will owe $2,500 (or $10,000 x 25%). When we factor in the itemized deduction of $2000, the taxpayer will now owe only $2,000 (or ($10,000 – $2,000) x 25%).
In this example, the $2,000 itemized deduction only saves the taxpayer $500 (or $2,000 x 25%) in tax owed.
When we take the $2,000 that the taxpayer owes (or ($10,000 -$2,000) x 25%) and apply the tax credit of $2,000, the taxpayer is left owing no tax (or $2,000 – $2,000). This is because each dollar of a tax credit actually eliminates a dollar of tax owed.
Therefore, in summary, it is ideal if you have both itemized deductions and tax credits that you can claim on your federal income tax, as there is no reason that a taxpayer cannot receive the benefit from both categories. But if a taxpayer has the option to take an equal dollar amount of itemized deductions or tax credits (but not both), the taxpayer will be better off taking the tax credit, because the tax credit reduces tax owed dollar for dollar rather than an amount that is only a fraction based on the effective tax rate.
If you have questions about your federal income tax, whether it is about understanding the itemized deductions and tax credits that you can take or simply getting help with preparing and filing your federal income taxes, you should contact a tax attorney.
- Medical Expenses and Federal Income Tax (taxlawhome.com)
- Federal Income Tax: Reducing the Amount you Pay (taxlawhome.com)
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- Itemized Deductions and Federal Income Tax (taxlawhome.com)
Mark has been a contributor to legal web sites related to bankruptcy, tax, and criminal law since 2011. He has an Accounting degree from Texas A&M University.