In a NutshellNo one wants to pay more than their fair share of income tax. Understanding the difference between a tax deduction and a tax credit can help ensure you don’t overpay when Tax Day arrives.
This article was fact-checked by our editors and Christina Taylor, MBA, senior manager of tax operations for Credit Karma. Portions of this article have been updated for the 2020 tax year.
You may know claiming tax deductions and tax credits can help lower the amount of tax you owe, but do you know the difference between the two?
While the end result of deductions and credits may be the same — you pay less in taxes — they work in different ways. Understanding the differences between tax deductions and tax credits can help ensure you stay organized, in control of your taxes, and ready to pay just the right amount when you file your income tax return.
- What is a tax deduction?
- What is a tax credit?
- What is the difference in how each works?
- What are the benefits of tax deductions?
- What are the benefits of tax credits?
- What are some common tax deductions and tax credits you might be eligible for?
- How to claim tax deductions and tax credits
- The forms you’ll need to claim deductions and credits
- Is there a maximum I can take for deductions and for credits?
- Beware these caveats
What is a tax deduction?
A deduction reduces the amount of income you pay taxes on, which means you could pay less in taxes. You subtract deductions from your income before calculating how much taxes you owe. How much a deduction saves you depends on your income tax bracket.
To calculate how much a deduction could reduce your taxes, you multiply the amount of the deduction by your marginal tax rate. For example, if a deduction is worth $5,000 and you are in the 10% tax bracket (the lowest), the deduction would reduce your taxes by $500.
A deduction’s value to you is tied to your tax rate. So if you’re paying a higher tax rate, you can reap more of a deduction’s benefit. The lower your tax rate, the less benefit a deduction will have for you. Imagine that you take a $5,000 deduction, but you’re in the 35% tax bracket — the second highest. Now you’re saving $1,750 in taxes.
What is a tax credit?
On the other hand, a credit is a dollar-for-dollar reduction in the amount of tax you owe. For example, if you qualify for a $1,000 tax credit of some kind and owe $5,000 in taxes, that credit will reduce your tax burden to $4,000.
What is the difference in how each works?
The big difference between tax deductions vs. tax credits is that deductions chip away at the income you’ll pay taxes on, which then reduces your taxes, while credits directly reduce the amount of taxes you owe.
Some tax credits like the earned income tax credit may even increase your refund, or provide you with a refund even if you didn’t owe any taxes. These are known as “refundable” tax credits. Tax credits are always refundable or nonrefundable.
Nonrefundable tax credits can’t increase your tax refund — they can only reduce the amount you owe in taxes. Imagine you get a $1,000 nonrefundable tax credit, but you only owe $500 in taxes. You won’t have to pay any taxes, but you also won’t get the remaining $500 from the credit back as a refund.
What are the benefits of tax deductions?
Tax deductions are designed to offset the amount of income you’ll pay taxes on by writing off expenses like tuition and healthcare, contributions to retirement, and any self-employed or capital gains losses you faced. Claiming a deduction ensures you don’t pay taxes on certain income you’ve already spent, invested or lost.
What are the benefits of tax credits?
In addition to reducing the amount you pay in taxes or increasing a refund, some tax credits can be claimed even if you have no tax liability. That means that if you don’t owe any taxes but qualify for $1,000 in refundable tax credits, you can get these credits as a $1,000 refund.
What are some common tax deductions and tax credits you might be eligible for?
Of course, Congress has the ability to change or eliminate deductions and credits, so it’s important to confirm a specific credit or deduction is still available before you try to claim it. You can do this by either by looking it up on the IRS website, consulting a tax professional or using a tax prep service.
Here are some common deductions and credits to be aware of.
- The standard deduction — Instead of itemizing deductions, many taxpayers claim a standard deduction because it can be simpler than itemizing all of their deductions individually. How much you can deduct using the standard deduction mostly depends on your filing status and age. For 2020, the standard deductions are $25,100 for people married filing jointly, $18,800 for those filing as head of household, and $12,500 for single and married, filing separately.
- Student loan interest — If you pay interest on a qualified student loan, you may be eligible to deduct up to $2,500. You don’t have to itemize deductions to take the student loan interest deduction.
- Medical and dental expenses — Qualified medical and dental costs are tax deductible as long as they exceed a set percentage of your adjusted gross income.
- State and local income tax — You may be allowed to deduct state, local and foreign income taxes.
- Property taxes — If you pay taxes for property like land, cars or boats, that tax may be deductible.
- Mortgage interest — If you pay mortgage insurance premiums, interest on a mortgage or points, they may be deductible.
- Retirement contributions — Contributions to a traditional 401(k) or a traditional IRA are often eligible for deductions.
- Contributions to a health savings account — If you have a high-deductible health plan and contribute to an HSA in conjunction with that plan, your HSA contributions are generally tax deductible.
- Earned income tax credit — If you are working and earn a low to moderate income, you could be eligible to claim the EITC, sometimes known as the EIC. This is a refundable tax credit. But be aware that claiming this credit could delay any tax refund you’re owed. That’s because federal law requires the IRS to hold the refunds of anyone who claims this credit until mid-February.
- Lifetime learning credit — Depending on your modified gross income, you may be able to get a credit for up to $2,000 for qualified tuition and education-related expenses for yourself, a spouse or dependent.
- Saver’s tax credit — This credit helps individuals who meet adjusted gross income requirements save for retirement. For 2020, the qualifying AGI is $66,000 for people who are married filing jointly, $49,500 for head-of-household filers and $33,000 for all other filing statuses.
- Residential energy-efficient property credit — As a homeowner, if you’ve invested in making your home more energy efficient, then you may be able to deduct those investments.
Can I take a personal exemption for my 2020 federal income taxes?
You can’t take any personal exemptions for your 2020 taxes. The Tax Cuts and Jobs Act of 2017 suspended personal exemptions for tax years after Dec. 31, 2017, and before Dec. 31, 2025.
How to claim tax deductions and tax credits
When you’re ready, it’s best to add up all the itemized deductions you might be able claim. From there, compare whether taking the standard deduction or itemizing your deductions provides the biggest reduction.
After applying all your deductions, you arrive at your taxable income and apply any credits you’re eligible for. This is the typical process for whittling down your tax bill to make sure you’re taking advantage of all deductions and credits you’re entitled to.
The forms you’ll need to claim deductions and credits
For deductions, you can claim the standard deduction on your Form 1040. But if you’re looking to itemize your deductions, you’ll need to fill out a Form 1040 and Schedule A.
For claiming credits, you must use Form 1040. For those claiming the earned income tax credit, you’ll need to fill out Schedule EIC if you’re planning on listing qualifying dependents.
Is there a maximum I can take for deductions and for credits?
For tax years between 2018 and Dec. 31, 2025, there is no overall limit on itemized deductions. The Tax Cuts and Jobs Act of 2017 repealed previous limitations that applied to upper-income taxpayers.
But individual limitations remain on certain deductions, such as medical and dental expenses.
When claiming the EITC or claiming dependent credits, you’re capped at certain maximums. For example, you’re limited to a $3,618 credit for one qualifying child in 2020. For credits like the foreign tax credit, the amount you’re eligible for is a fraction comprising the tax paid to non-U.S. tax entities divided by the total amount owed the IRS and entities abroad.
Beware these caveats
A drawback of claiming the EITC is that it can sometimes delay your refund. The IRS now holds EITC recipient refunds until at least February 15 before distributing.
Also, if you’re married but filing separate returns, and you want to itemize deductions, your spouse will also have to itemize. Likewise, if either of you want to use the standard deduction, the other must do the same as well.
Also for itemizing, you must have well-documented records to claim certain deductions, which is generally more work to prepare than simply claiming the standard deduction. For example, if you’re claiming business use of your car, you often need proof in the form of a mileage log delineating business and personal use.
They work in different ways, but both tax deductions and tax credits can help reduce the amount of taxes you pay. Understanding the difference and how each works can help ensure you maximize the value of every deduction or credit you’re eligible for. Plus, doing your homework before filing can help you identify every opportunity to use a tax deduction or credit to save you money.
Christina Taylor is senior manager of tax operations for Credit Karma. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is the current treasurer of the National Association of Computerized Tax Processors and holds a bachelor’s in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on LinkedIn.