Tax Deductions vs Tax Credits: What's the Difference?

Tax deductions and tax credits are two of the most common ways to reduce your tax bill. But what's the difference between them? Tax deductions reduce your total taxable income, the amount you use to calculate your tax bill. On the other hand, tax credits are deducted directly from the taxes you owe. Some tax credits are even refundable, meaning that if the credits reduce your tax bill to less than zero, you'll get a refund for the difference.

A tax credit is a dollar-for-dollar reduction in the income tax you owe. Pre-tax deductions are deducted from an employee's paycheck before taxes are withheld. Because they are excluded from gross payment for tax purposes, pre-tax deductions reduce taxable income and the amount of money owed to the government. They also lower your federal unemployment tax (FUTA) and state unemployment insurance fees.

Individual states have their own guidelines for reporting payroll deductions, so it's important to check with local authorities. If you hire independent contractors, you generally don't have to withhold income tax, Social Security tax, or Medicare tax from your salaries. The lifetime learning credit is non-refundable, so if you don't have any taxable income or your tax liability is reduced to zero, no refund will be generated. They consist of federal income tax, the Federal Insurance Contributions Act (FICA) tax (Medicare and Social Security) and the state income tax.

Many self-employed people think that if they establish their business as a corporation or other type of business structure, they can get more tax cancellations (tax deductions) than if they establish themselves as a sole proprietor, but this is a myth. With deductions, you can take the standard deduction or itemize it, but you can't do both. Incorrect payroll deductions are often the result of employers charging their employees for benefits and services that they should pay for themselves. A credit lowers your taxes, giving you a greater refund of your withholding, but certain tax credits can give you a refund even if you don't have any withholding.

You can send Form SS-8, Determination of Worker Status for Federal Employment Taxes and Income Tax Withholding, to the IRS for further assistance. Ultimately, however, the IRS tax code determines what deductions a business qualifies and doesn't qualify for. Each company will have some expenses that are specific to their business or industry that could possibly be a tax waiver. The additional medical tax also applies to certain levels of compensation for railroad retirement and self-employment income. If you incorrectly deduct garnishments or don't pay them in full, your company could be responsible for the late payments, not the employee.

While capital expenditures are items such as investments or real estate that also qualify for deductions if purchased to generate business income. Deborah Todd, CPA and president and CEO of iCompass Compliance Solutions, agrees that credits are a more valuable way to lower your taxes.