Tax credits and tax deductions work differently, with deductions lowering your taxable income and credits actually reducing the taxes you owe.
To be a little more specific, deductions can decrease the amount of income you have to pay taxes on, which can lower your final bill. Tax credits are a dollar-for-dollar reduction in what you owe — and might even get you a bigger tax refund.
It’s possible you may be able to claim both deductions and credits. Read on to understand more about how both options work.
What Are Tax Credits?
Tax credits represent a dollar-for-dollar reduction in your overall tax burden. They directly lower the tax amount you owe to Uncle Sam.
For example, if you owe $1,500 in taxes but qualify for a $500 tax credit, your total tax bill will decrease by $500, meaning you’ll only have to pay $1,000.
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How Do Tax Credits Work?
When filing your taxes, you can use IRS resources, tax software, or a certified accountant to research tax credits for which you may be eligible. If it’s your first time filing taxes, these resources can be especially helpful.
Even if you don’t owe anything in taxes, it’s worth looking into tax credits. Why? Because some tax credits are refundable, meaning the government might owe you money:
• Refundable tax credits allow your tax liability to go below zero. For example, if you owe $100 in taxes but receive a $500 refundable tax credit, the government will actually owe you $400.
• Nonrefundable tax credits do not work that way, unfortunately. If you qualify for a nonrefundable tax credit, the best it can do is eliminate your tax liability (meaning you owe nothing). But even if the credit is large enough to wipe out what you owe and there’s still money left over, you don’t get to pocket that extra money.
Tax credits are not for everyone. Each credit has specific requirements to qualify.
And if you’re wondering what happens if you miss the tax deadline, tax credits would still apply for the year that you’re filing your taxes.
Common Tax Credits
Your tax software or accountant should know the full list of tax credits to look out for, and the IRS website features the whole list. (You can also learn important information from an online tax help center.)
Before diving into your taxes, however, it’s a good idea to note some of the most common tax credits for which you may qualify:
• Earned Income Tax Credit: Commonly called by its initials (EITC), this refundable tax credit is for low- to moderate-income workers. The amount you might qualify for and your eligibility can vary depending on whether you have dependents and/or have a disability.
• American Opportunity Tax Credit: This education tax credit is partially refundable. Students (or parents claiming a student as a dependent) can claim this tax credit for the first four years of higher education. It’s $2,500 per eligible student, but once your tax bill hits zero, you can earn 40% of whatever remains (up to $1,000) as a tax refund.
• Child Tax Credit: Even if a child isn’t enrolled in higher education, parents have access to a handy tax credit. The Child Tax Credit is a refundable tax credit for parents (with dependent children) who meet income requirements.
• Child and Dependent Care Credit: Parents have access to yet another potential tax credit, this time for those who pay for babysitters or daycare. The credit amount depends on such factors as your income, child care costs, and number of children requiring care.
You can use tools on the IRS website to discover if you qualify for these and other tax credits.
What Are Tax Deductions?
Tax deductions are another way to reduce your tax burden, but they work differently. While a tax credit discounts your final tax bill after all the calculations, a tax deduction reduces the amount of income eligible for taxes.
The more deductions you have, the less money you have to pay taxes on. This can result in a lower overall tax bill, but it cannot result in a tax refund.
Recommended: What Triggers an IRS Audit?
How Do Tax Deductions Work?
Let’s look at an example to understand how tax deductions reduce what you owe:
If you made $100,000 in a given year, you would owe 24% in federal taxes based on your marginal tax bracket. But if you have $10,000 in tax deductions, you would lower your taxable income to $90,000, which puts you at both a lower base to calculate taxes ($90K vs. $100K), and you would be in the 22% tax bracket, which this year is capped at $95,375 for single filers.
As you can see, when calculating how much a tax deduction will save you, it’s important to know which tax bracket you’re in — your tax bracket represents the percentage at which your income could be taxed. In general, the more money you make, the higher the tax rate.
Common Tax Deductions
Nearly every tax filer is eligible for the standard deduction. Without inputting any information accounting for business expenses, medical costs, charitable contributions, student loan interest payments, and other eligible deductions, you can simply subtract the standard deduction amount from your taxable income.
For the 2023 tax year (which will be filed in April of 2024), the standard deduction is:
• $13,850 for single taxpayers (and married, filing separately)
• $27,700 for married taxpayers filing jointly
• $20,800 for heads of household.
Many people choose to take the standard deduction, but if you qualify for various deductions that would amount to more than the standard deduction, it’s worth itemizing your deductions.
Working with a personal accountant or tax preparation software may be your best bet for determining which deductions you qualify for. Here are some of the most common types of deductions:
• State and local taxes
• Business expenses (if you are self-employed)
• Mortgage interest
• Property taxes
• Qualifying medical expenses
• Charitable contributions
• Student loan interest.
You can explore even more tax deductions on the IRS website.
If you run your own business, it’s wise to look into common tax deductions for freelancers.
Pros and Cons of Tax Credits
Tax credits are largely a good thing, as they reduce your overall tax burden. But they also have some drawbacks. Here’s a closer look at the pros and cons:
Pros
First, consider these upsides of tax credits:
• Reduces your tax bill
• May result in a refund
• Often designed for moderate- to low-income families.
Cons
Next, the potential downsides of tax credits:
• Strict eligibility requirements
• Can delay your refund when you claim them.
Recommended: How to File for a Tax Extension
Pros and Cons of Tax Deductions
Similarly, tax deductions serve a useful purpose in filing taxes, but they also have their own set of pros and cons.
Pros
Here are the potential advantages of tax deductions:
• Reduces your tax bill
• The standard deduction is easy to claim
• Useful for self-employed individuals with business expenses.
Cons
Also be aware of the possible downsides:
• Lots of paperwork (itemized deductions)
• Weighing the standard vs. itemized deduction can be complicated
• Won’t generate a refund.
Tax Credits vs Deductions: What’s the Difference?
Let’s break down the differences between tax credits and tax deductions in chart form:
| Tax Credits | Tax Deductions |
|---|---|
| Dollar-for-dollar reduction in your total tax bill | Reduction in how much income you have to pay taxes on |
| Can result in a tax refund | Can only reduce taxable income; cannot result in tax refund |
| Must claim specific credits for which you qualify | Can take the standard deduction or itemize your deductions |
| Only available to filers who meet specific criteria | Available to most filers as standard deduction |
While nearly everyone can qualify for the standard deduction, tax credits can actually be the more effective way to lower your tax bill. But the best part? You can utilize both tax strategies when you file.
Tips for Using Tax Credits and Deductions
Preparing to file your taxes? Here are some tips for using tax credits and deductions:
• Research eligibility requirements online: The IRS website has useful tools to help determine if you qualify for specific tax credits and deductions.
• Gather all your paperwork: Taxes require a lot of forms, documents, and receipts. When claiming credits and deductions, it’s important to have the paperwork (whether printed or digital) to prove your eligibility.
• Consider using tax software or an accountant: Taxes can be overwhelming. If your situation is complex (maybe you are confused by, say, your payroll deductions), you may benefit from tax software (TurboTax, H&R Block, and TaxSlayer are popular brands) or a tax professional.
The Takeaway
Tax credits and tax deductions can both lower your overall tax burden. Tax credits reduce what you owe dollar-for-dollar, while tax deductions reduce the amount of income you owe taxes on. If you’re eligible, you can take advantage of both tax strategies when you file.
While you are getting your taxes organized, don’t overlook the value of a banking partner that makes it easy to manage your finances.
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FAQ
Between a tax deduction and tax credit, which lowers your bill more?
A tax credit lowers your tax bill dollar-for-dollar and may even result in a refund. A tax deduction only reduces the amount of money you owe taxes on. For example, a $1,000 tax credit takes $1,000 off your tax bill. A $1,000 tax deduction reduces your taxable income by $1,000; the actual reduction in tax depends on your tax bracket.
Do more people utilize tax credits or tax deductions?
Most tax filers can claim the standard deduction, but not everyone qualifies for tax credits. So it is more likely that you’ll use a tax deduction on your tax return than a tax credit. That said, it is possible to use both credits and deductions to lower your tax bill.
Can I claim both deductions and tax credits?
Yes, you can claim both tax deductions and tax credits on your tax return, as long as you qualify for the deductions and credits you claim.
Photo credit: iStock/Jinli Guo
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