When filing your IRS tax return, it’s essential to understand how tax credits and deductions work. While both can reduce the taxes you owe, they do so in distinct ways.
Tax credits vs. Tax deductions
Tax credit: A tax credit directly reduces the amount of tax you owe on a dollar-for-dollar basis. For example, if you owe $5,000 in taxes and claim a $1,000 tax credit, your tax liability drops to $4,000. Certain credits, like the Earned Income Tax Credit (EITC), may even result in a refund if the credit exceeds your tax liability.
Tax deduction: A tax deduction reduces your taxable income, which lowers your overall tax liability. Deductions are calculated based on your tax bracket. For example, a $1,000 deduction in the 22% bracket saves $220 in taxes. Common deductions include contributions to retirement accounts or student loan interest payments.
Key difference: Tax credits directly reduce taxes owed, while deductions lower taxable income and indirectly reduce taxes.
How to calculate a tax deduction and a tax credit
Assume an adjusted gross income (AGI) of $50,000 and a tax credit vs. a tax deduction of $10,000.
| Tax Deduction | Tax Credit | |
| AGI | $55,000 | $55,000 |
| Tax Deduction | -$5,000 | |
| Taxable income | $50,000 | $55,000 |
| Tax rate | 22% | 22% |
| Tax calculated | $11,000 | $12,100 |
| Tax credit | -$5,000 | |
| Taxes Owed | $11,000 | $7,100 |
The example is based on a single filer using 2024 Income Tax Brackets and Rates.
As you can see, in this simplified example, the tax credit reduces taxes owed more than the tax deduction does.
However, real-life situations are often more complex and may have limitations that may limit how much tax relief you can claim.
Types of tax credits
Refundable vs. Non-Refundable
- Refundable credits: These can reduce your tax liability below zero, resulting in a refund. For example, the Child Tax Credit (CTC) is partially refundable, allowing up to $1,700 back as cash if your tax liability is zero.
- Non-Refundable credits: These reduce your tax bill to zero but do not generate a refund for any excess credit amount. For instance, the Lifetime Learning Credit (LLC) is non-refundable but offsets education costs.
Popular tax credits
- Earned Income Tax credit (EITC): Targets low- to moderate-income earners, providing a refundable credit based on income and family size.
- Electric Vehicle (EV) credit: Offers up to $7,500 for purchasing a qualifying EV, though it’s non-refundable and subject to income limits.
- Child and dependent care credit: Reduces the cost of childcare for working parents.
Types of tax deductions
Above-the-line deductions
These apply to your gross income before calculating AGI, benefiting all filers regardless of whether they itemize deductions. Examples include:
- Contributions to Health Savings Accounts (HSA) or IRAs.
- Self-employment expenses like health insurance premiums.
- Student loan interest payments.
Below-the-line deductions
Below-the-line deductions are claimed after AGI and fall into two categories:
- Standard deduction: A fixed amount set annually. For 2024, the standard deduction is $14,600 for single filers and $29,200 for married couples filing jointly.
- Itemized deductions: Used when qualifying expenses exceed the standard deduction. Examples include mortgage interest, charitable donations, and medical expenses exceeding 7.5% of AGI.
Choosing between credits and deductions
The choice between taking a credit or deduction often depends on eligibility, income level, and potential savings. Tax credits generally offer more significant benefits but may have stricter qualifications. Meanwhile, deductions provide flexibility for reducing taxable income, especially with options like standard or itemized deductions.
Tips for maximizing savings
- Keep Records: Maintain documentation for expenses and credits, such as receipts for charitable donations or tuition payments.
- Review IRS Guidelines: Each credit and deduction has specific eligibility rules and income limits. Visit IRS.gov for the latest updates.
- Consult Professionals: A tax advisor can help identify the best options for your situation, especially if you experience major life changes like buying a home or having a child.
