Government has social agendas. Some change is done through rules and laws while others are encouraged through financial incentives. For example, EVs or electric vehicles, which are supposedly better for our environment but do not make financial sense to own. They are more costly to produce and therefore purchase and the electricity is not necessarily cheaper than gasoline. Yet the US government wants us to be driving in EVs, so a tax credit of $7,500 was introduced, essentially making it $7,500 cheaper to purchase an EV, significantly closing the gap on the cost differential with a gasoline engine vehicle.
A tax credit is when you receive a discount dollar for dollar on the taxes you owe. To fully understand the concept of tax credits, it is important to understand the difference between a deduction and a credit as well as the difference between a refundable credit and a non-refundable credit. Misunderstanding these can be costly if you make a decision to buy something, pay for something, etc. assuming it would be subsidized by some tax savings and those savings don’t materialize.
A deduction is when you are allowed to reduce your income by an amount of dollars. This saves you the taxes you would have had to pay on this income. For example, there is a deduction allowed for student loan interest. A taxpayer in the 22% tax bracket with $2,500 in student loan interest, would save $550 in income tax ($2,500 x 22%).
In contrast, a credit is a reduction in the taxes owed. If the student loan deduction were a tax credit (it is not) then the $2,500 in interest would save $2,500 in income tax.
Which is better, a deduction or a credit? Yes, you are correct! A tax credit is far better than a tax deduction, for most of us it is about 4-5 times better.
What happens if you are eligible for a $2,500 tax credit but you only have a tax liability of $2,000? What happened to the extra $500 of credit?
This would depend on whether the credit is a refundable credit or a non-refundable credit. A refundable credit is a credit that you receive regardless of your tax liability, it is as if you paid that money as taxes and you would receive the last unused $500 credit as a tax refund.
With a non-refundable tax credit, the last $500 of unused credit would be lost. A non-refundable credit can only get your tax liability to $0 and then it is lost.
Some examples of refundable credits are some of the child tax credit, the earned income credit and the American Opportunity credit. Some examples of non-refundable tax credits include the EV credit, Child and Dependent Care credit and Lifetime Learning credit.
It is important to note that many deductions can be carried over to the next year if unused whereas credits do not carry over. An unused non-refundable credit is lost forever.
Why is it important to know this?
Let’s look at our first example, an EV. The salesman will likely tell you that the tax credit will make the car affordable for you. If you did not know any better, you might buy the car when you really are unable to afford it. If you only have $3,000 in taxes, then the remaining $4,500 of the tax credit would be lost.
This has implications on whether you should buy the car or not but also on whether you should delay or accelerate the purchase to a better tax year.
As you can see, tax deductions and credits are complex. It is best to have someone who understands it, be in your corner. So, reach out today and book a consultation with our team.
