Tax Deductions vs. Tax Credits: Key Differences High Earners Need to Know in 2024

Tax Deductions vs Tax Credits for High Earners: What You Need to Know

Dan Pascone | Mar 25, 2024

As your earnings increase, the intricate dance between tax credits and deductions becomes crucial to keeping more of your hard-earned money in your pocket.

Think of it this way: tax credits and tax deductions are two independent games you play during each tax year. Both can help you optimize your tax scenario, but each has its own rules, strategies, and limitations.

Here’s why it’s critical to learn this stuff sooner rather than later: saving money today at a high marginal tax rate allows you to put that money to work, reaping a more significant payout in the future.

Tax credits versus tax deductions isn’t just about choosing between two paths– it’s about understanding the whole map ahead and how to play it to your strengths.

The following guide explores how tax credits and tax deductions differ, which are better for you, and common examples of each within reach for high earners.

Tax Credits: Your Dollar-for-Dollar Hero

Think of a tax credit as a direct discount on your tax bill.

Let’s say you owe $2,000 in taxes and snag a $2,000 tax credit, voilà—your tax bill vanishes.

But, be aware that not all tax credits are created equal.

Tax credits come in three flavors: non-refundable, refundable, and partially refundable.

Some are non-refundable, meaning they can only bring your tax bill to zero but not a penny more.

So, if you have $2k of tax liability and a $3k tax credit, you'd bring your tax liability to $0 but would burn the excess $1k of the credit.

Other tax credits, like the Earned Income Tax Credit or the Child Tax Credit, are refundable and can even result in a nice check from the IRS if they exceed your tax liability.

Partially refundable credits offer a blend of the two, offering some refund potential.

Tax Deductions: The Income Shrinker

On the other side, we've got tax deductions.

Tax deductions reduce your taxable income, not the tax owed directly.

Suppose you’re in the 24% tax bracket and claim a $2,000 deduction; you’d save $480 in taxes ($2,000 * 24% = $480).

Tax deductions might have less impact than tax credits, but they’re still nothing to scoff at– they can quickly add up and knock tens of thousands of dollars off your tax bill every year.

The IRS offers taxpayers an easy way out of meticulously calculating all of their deductions with the Standard Deduction.

The Standard Deduction is a specific dollar amount based on your filing status and age that reduces your taxable income with no questions asked.

For the 2023 tax year, the standard deduction amounts are as follows:

Single: $13,850
Married Filing Jointly: $27,700
Married Filing Separately: $13,850
Head of Household: $20,800

The easy route doesn’t necessarily mean you’re leaving money on the table, but it’s worth at least knowing the range of deductions you could claim should you choose to itemize.

You have to choose between the standard deduction and itemizing your deductions—you can’t claim both in the same tax year.

However, it’s usually better to itemize if the sum of your itemized deductions exceeds the standard deduction amount. There isn't an issue with itemizing, and any CPA will ensure this is done correctly. This typically requires working with a bookkeeper (or being on top of your own accounting) during the calendar year, so you can make any final purchases before the tax year ends– and also avoid the accounting scramble come March & April.

It’s best practice that your CPA and financial planners communicate with each other, so be sure to make the proper introductions and avoid playing messenger with critical financial information.

It’s worth noting that W-2 employees will typically benefit more from standardized deductions than business owners, as the latter tends to have a larger pool of deductions they can make.

The following list contains some of the most substantial potential itemized deductions that would make it better to itemize:

Mortgage Interest: If you have a sizable mortgage interest deduction, itemizing might make more sense.
State and Local Taxes: State and local income and property taxes can add up, especially in high-tax states, potentially making itemizing more attractive. There is a $10,000 cap on these deductions.
Charitable Donations: Large contributions to charities could boost your itemized deductions.
Medical Expenses: Medical expenses exceeding 7.5% of your adjusted gross income could be itemized to offer more tax relief.

You can visit the IRS's website for more detailed information on the standard deduction.

Tax Credits vs. Tax Deductions: The Showdown

Now, you typically don’t need to trade between credits and deductions, but let’s assume you must choose between a $10,000 tax deduction and a $10,000 tax credit with a taxable income of $100,000. You’re in the 24% tax bracket.

Opting for the deduction would lower your tax bill from $24,000 to $21,600.

Choosing the credit would slash your tax bill down to $14,000.

The tax credit clearly takes the crown in this scenario.

But you might just be able to choose both, as long as you qualify.

You can cast the widest net for what’s available with proper strategy and working with a financial planner. Planning ahead– especially when it comes to making decisions within a current tax year rather than filing time the following year, can be very worth the extra series of tasks.

High earners can reach marginal tax rates as high as 37%– a third of their income– so if you have deductions available that exceed the standard deduction, be sure to use them.

Credits typically favor lower-income taxpayers, but there are plenty within reach for high-earners.

Tax deductions are plenty, but they require you to exercise responsible and sound judgment regarding what you should or shouldn’t claim. You always have the standard deduction should you prefer the easier route.

11 Tax Credits for High Earners

Although tax credits can be way more impactful than tax deductions, they’re often ignored (and misunderstood) by people in a perfect position to claim them.

Remember, if you snag a $1,000 tax credit, you reduce your tax bill by the same amount. In contrast, a $1,000 deduction saves you $240 if you're in the 24% tax bracket.

Here’s a shortlist of the lowest-hanging fruit. Be mindful that most, but not all, of these credits have limitations if your income exceeds a certain amount.

Lifetime Learning Credit (LLC): Ideal for those pursuing further education, certifications, or training relevant to their field, offering up to $2,000 per tax return.
Child and Dependent Care Credit (CDCC): Beneficial for tech professionals with children, this credit helps offset childcare costs, offering up to $2,000 per child under 17, with a portion refundable under certain conditions.
Energy Efficient Home Improvement Credit: For tech professionals interested in making their homes more energy-efficient, this credit provides incentives for upgrades, and it offers an annual tax credit of up to $3200.
Residential Clean Energy Property Credit: Encourages investments in renewable energy sources like solar panels, aligning with environmentally conscious values prevalent in tech culture.
American Opportunity Tax Credit (AOTC): If you're supporting a child through the first four years of college, this credit can ease the financial burden, offering up to $2,500 per student and partially refundable up to $1,000
Electric Vehicle Tax Credit: Purchasers of a new, qualified plug-in EV or fuel cell electric vehicle (FCV) vehicle can get up to $7,500
Research & Development Tax Credit: This credit provides a credit for qualified research expenses, which vary widely depending on the expenses.
Foreign Tax Credit: Credits for taxes paid to foreign governments, dollar-for-dollar, against U.S. tax liability on the same income.
Nonrefundable Credit for Prior Year Minimum Tax: You might be eligible if you paid AMT in previous years.
Mortgage Interest Credit: IRS Form 8396 is used for the mortgage interest credit.
Investment Credit (Form 3468): This is a bundle of various credits, like the Rehabilitation Credit, Energy Credit, and Qualifying Advanced Coal and Gasification Credit, designed to incentivize investments by allowing businesses to claim a credit for a portion of their investment in certain properties or projects, such as those that improve buildings, utilize renewable energy, or involve advanced coal or gasification technology.

Various niche business credits can be found on the IRS’s list of General Business Credits.

Tax Credits: What’s the Catch?

Tax credits reflect policies that encourage specific behaviors or stimulate a certain income level.

We’ve included a small segment of credits that may apply to the various scenarios in which high-income earners find themselves. Still, there are dozens of credits specifically aimed at lower-to-middle-income tax brackets.

Still, you can align your actions with some of these incentives, which may benefit your financial health.

Whether you're pondering solar panels, saving for your kid’s education, or buying a new Tesla, these credits can be one of your best financial friends.

Although tax credits usually offer more bang for your buck than deductions, their availability is much narrower than the array of deductions available to high-earners.

10 Common High Earner Tax Deductions

Before you dive into itemizing every single deduction, remember the standard deduction—a set amount based on your filing status that reduces your taxable income with no questions asked.

Mortgage Interest Deduction: High earners can deduct interest on mortgages up to $750,000 for homes bought after December 15, 2017. For homes purchased before this date, the limit is $1 million.
State and Local Taxes (SALT) Deduction: You can deduct state and local sales, income, and property taxes up to a combined limit of $10,000 ($5,000 if married filing separately).
Charitable Contributions: Contributions to qualified organizations can be deducted, with limits based on a percentage of adjusted gross income (AGI).
Investment Interest Expense: Interest paid on money borrowed to purchase investment property can be deducted and limited to net investment income.
Home Office Deduction: If part of a home is used exclusively for business, a portion of household expenses can be deducted. This is more common for self-employed high earners.
Retirement Plan Contributions: Contributions to traditional IRAs and 401(k)s can reduce taxable income, subject to annual limits.
Health Savings Account (HSA) Contributions: Contributions to an HSA are deductible, provided the taxpayer is enrolled in a high-deductible health plan.
Medical and Dental Expenses: Expenses exceeding 7.5% of AGI can be deducted, including payments for diagnosis, cure, mitigation, treatment, or prevention of disease and treatments affecting any structure or function of the body.
Work-Related Education Expenses: Education expenses that maintain or improve job skills or are required by an employer or by law can be deductible.
Investment Advisory Fees: While miscellaneous itemized deductions subject to the 2% floor are suspended, investment advisory fees related to tax-exempt income are still deductible.

If your itemizable deductions are within the standard deduction, take the easy route and claim it.

Final Thoughts: Tax Laws and Tax Credits Right for You

In summary, tax credits usually offer more savings as they reduce your tax bill dollar-for-dollar, while deductions lower your taxable income.

The type of credits may be limited, whereas a wider pool of potential deductions is available regardless of filing status.

The more money you make, the fewer tax credits you likely have available, but you’ll likely have higher deductions. W-2 employees may tend to have fewer deductions available than business owners, but they still have all the same tax credits available, given they meet the criteria.

The higher your tax bracket, the more significant the impact of the deduction or credit.

Navigating the intricate world of tax credits and deductions feels like solving a complicated puzzle– fun if you’re into it but frustrating if you have other things you’d prefer to do.

This is where a quick meeting with a financial planner who has specific experience working with high-earners in tech can yield substantial results. It’s not just about understanding the rules; it’s about crafting a tailored approach in a landscape where one size doesn’t fit all.