- Both tax credits and deductions help reduce your tax obligations and lower your tax bill.
- Credits reduce your tax bill dollar for dollar and may contribute to your tax refund.
- Deductions lower your tax bill by reducing your taxable income, allowing you to earn some income tax-free.
A savvy tax strategy often hones in on minimizing local, state and federal tax payments, while still meeting one’s tax obligations. Credits and deductions are two ways taxpayers can reduce the amount of tax they owe, but they work in distinct ways to lower your tax bill.
Here, we’ll discuss the difference between tax credits and tax deductions, how each one works, and common credits and deductions you may claim when filing your taxes.
At a glance: Tax credit vs. tax deduction
Broadly speaking, tax credits and tax deductions serve the same general purpose — to reduce the amount of tax one owes. A tax credit directly reduces your tax bill by a dollar amount. A tax deduction indirectly reduces your taxable income at the rate of your tax bracket.
Some key differences between tax credits and deductions include:
|Tax Credits||Tax Deductions|
|Tax Benefits||Reduces tax liability||Reduces tax liability|
|How They Work||Subtracted from the amount of tax you owe. Refundable tax credits may also increase the refund received, if you are eligible, when you file your income tax return||Reduces your adjusted gross income (AGI) or taxable income.|
|Potential Impact on Taxes Owed||Directly reduces your tax bill by a dollar amount. How much you save is determined by your eligibility for various credits.||Indirectly reduces your tax bill by lowering your taxable income. The amount saved will vary based on your income level, method of deduction and filing status.|
Tax credits explained
Tax credits have a fairly straightforward impact on one’s tax liability: each dollar of tax credits allows for a dollar reduction in your tax bill overall. However, tax credits fall into two distinct categories you should be aware of: refundable credits and nonrefundable credits.
Refundable credits have the potential to contribute to a tax refund if the value of the tax credit is larger than the amount of tax owed. For example, an individual eligible for $3,000 in refundable tax credits, with a $2,000 tax liability, could receive a refund for $1,000. Some credits are fully refundable, meaning the entire value of the tax credit can contribute to a refund, whereas others are only partly refundable.
Nonrefundable tax credits reduce one’s tax liability, but cannot contribute toward a tax refund. If the individual above was eligible for $3,000 in nonrefundable tax credits, for example, they could reduce their tax obligation to $0, but they would not receive a tax refund.
Some refundable and nonrefundable tax credits available in the United States include:
- Earned income tax credit (EITC): A refundable tax credit to help lower- and moderate-income families reduce their tax obligations.
- Child tax credit: A fully refundable tax credit for families with a qualifying child under 18.
- Child and dependent care credit: A nonrefundable tax credit intended to help working families cover work-related child care expenses.
- American opportunity tax credit: A refundable credit to help families manage the cost of the first four years of higher education after high school.
- Lifetime learning credit: A nonrefundable credit used to cover education expenses, including tuition and fees for graduate school and professional degree courses.
- Premium tax credit: A refundable tax credit to help families cover the cost of health care insurance premiums.
- Saver’s credit: A non-refundable tax credit that may be applied to up to 50% of a taxpayer's eligible contributions to a retirement account, such as an employer-sponsored retirement plan.
Tax deductions explained
Tax deductions are used to calculate your taxable income. They help lower your AGI and thus your overall tax liability. The overall amount saved depends on your tax bracket and marginal tax rate, as well as your filing status, namely, whether you’re filing as single, head of household or a married couple (filing jointly or separately).
When claiming deductions, taxpayers have two general options: claim a standard deduction or claim itemized deductions. The standard deduction lowers your AGI by a standardized amount set by the Internal Revenue Service (IRS) each tax year, while itemized deductions reflect what you actually spent on deductible expenses.
Each approach has benefits and drawbacks. Claiming the standard deduction does not require additional documentation, making it relatively straightforward to claim. However, it may be less than the sum of your itemized expenses, meaning you may end up claiming fewer deductions than you would be entitled to otherwise and sacrificing some tax savings for convenience.
If the sum of your itemized deductions is larger than the standard deduction, you can minimize your tax liability by opting to claim itemized deductions. However, you will need supporting documentation for your expenses to show the IRS in case of an audit.
Some commonly claimed deductions in the United States include:
- Health care deductions: Deductions for qualified dental expenses and qualified costs incurred in accessing medical care (although there is a maximum percentage cap that can be deducted based on your AGI).
- Charitable donations: Cash or noncash contributions to a qualified organization.
- Home mortgage interest deduction: Married couples can deduct mortgage interest on the first $750,000 in value on their home (or $375,000 if married filing separately).
- Property tax deduction: Claimants can deduct state and local taxes, property taxes and sales taxes, up to a combined total of $10,000.
- Student loan interest deduction: Students may deduct up to $2,500 in student loan interest paid in a given tax year (based on qualified school expenses).
- Investment-related deductions: Deductions for capital losses, real estate taxes related to the sale of a home, qualified contributions to an individual retirement arrangement (IRA) savings account and more.
- Deductions for business expenses: Self-employed individuals may be able to claim additional deductions, including home office deductions, per IRS guidelines
Before you file
Credits and deductions can help filers ensure they aren’t paying more than they need to, and claiming the credits and deductions you’re eligible for may help reduce your bill or increase your refund when you file your tax return. However, each individual’s situation is unique: consider consulting a tax professional for tax preparation and tax filing to ensure you’re utilizing the most efficient strategy for your situation.