Financial Fact: Terms You Should Know, Part 2

When it comes to taxes, most of us just want to get them done quickly and as painlessly as possible. But if you’ve ever found yourself puzzled by terms like deduction and credit, you're not alone. In the second installment in our two-part series, we break these terms down in a way that makes sense.

Imagine you’re trying to knock down a brick wall (the tax you owe) with a hammer or a sledgehammer. A deduction is like the hammer, slowly chipping away at your taxable income, while a credit is the sledgehammer that directly reduces your tax bill.

Deductions: A deduction reduces the amount of your income that’s subject to taxes. For instance, let’s say you made $50,000 last year, and you have $10,000 in deductions (from things like charitable contributions, mortgage interest, or student loan interest). Instead of being taxed on your entire $50,000, you’re only taxed on $40,000. Deductions help lower your taxable income, which in turn lowers the amount of taxes you owe, but it doesn’t directly reduce your tax bill. (SmartAsset, Dec. 2023)

Deductions come in two main forms: the standard deduction and itemized deductions. The standard deduction is a flat amount the IRS lets you deduct depending on your filing status (single, married filing jointly, etc.). While standard deductions are preset, itemized deductions are expenses the taxpayer incurred, such as mortgage interest, state or local income taxes, property taxes, medical or dental expenses, or charitable donations. Speak to your tax preparer about whether taking the standard deduction or itemizing is best for your individual financial situation. (NerdWallet, Nov. 2023)

Credits: A credit, on the other hand, is even better. While deductions only reduce your taxable income, a credit is like getting a gift card for your taxes—it directly reduces the amount you owe. For instance, if you owe $2,000 in taxes but you have a $500 credit, you now owe only $1,500. Credits come in two varieties: nonrefundable and refundable. Nonrefundable credits can only reduce your tax bill to zero, but no further. Refundable credits, like the Earned Income Tax Credit (EITC), can not only reduce your tax bill to zero, but the IRS will send you the difference if your credit exceeds what you owe. For example, if you owe $1,000 but have a $1,200 credit, you will receive $200 back from the IRS once the credit has been used to pay the amount you owe. Now that's a win! (SmartAsset, Dec. 2023)

In short, deductions reduce the amount of income you’re taxed on, while credits reduce the actual tax bill dollar-for-dollar. Make sure to check which deductions and credits you qualify for and to consult a tax expert who has experience with clergy taxes. Getting a handle on the basics can go a long way to making tax season less stressful—and maybe even a bit more rewarding!

Sources:

• SmartAssets, "Differences of Tax Credits vs. Tax Deductions," by Rebecca Lake, Dec. 20, 2023
• NerdWallet, "Tax Deductions vs. Tax Credits," by Tina Orem, Nov. 9, 2023
• IRS.gov, "Credits and Deductions for Individuals," August 2024 (https://www.irs.gov/credits-and-deductions-for-individuals)
• IRS Publication 17, Your Federal Income Tax (2022)
• IRS Form 1040 Instructions (2023)