Key differences between tax credits and tax deductions
Both tax credits and deductions lower what you owe, but they act at different points in the math: a deduction works before your tax is calculated, directly affecting your Adjusted Gross Income (“AGI”), while a credit works after, and certain credits can create a “refundable” amount to you above what you already paid in taxes. Without a refundable credit, any money that you receive back as a result of your tax return would be from payments made to the IRS, either through direct payments or withholdings.
| Tax deduction | Tax credit | |
|---|---|---|
| What it reduces | Taxable income. | The tax you owe. |
| How much it saves you | Depending on your tax bracket, the higher the bracket the more the percentage of savings. | Fixed credits are the same dollar amount for everyone who qualifies, while others may depend on factors like income, family size, expenses. |
| Refundable? | Deductions aren’t refundable, they only reduce what amount is taxed. | Some credits are refundable, others aren’t. |
Source: Internal Revenue Service
How tax deductions work
A tax deduction is subtracted from your income before your taxes owed are calculated. Every filer has to choose between:
- Standard deduction: A flat amount determined by your filing status. This also can be increased for those over 65, and/or those who are blind; or might be limited if you can be claimed as a dependent.
- Itemized deductions: A running list of qualifying expenses that can be deducted from your taxable income.
If your eligible itemized expenses exceed the standard deduction for your filing status, you’ll typically itemize.
For example, if you’re a single filer and your eligible itemized expenses are only $4,800, you would take the standard deduction ($15,750) since it’s larger. However, if you’re a couple filing jointly and your eligible itemized expenses add up to $41,000, itemizing would save you more than taking the standard deduction, which is only $31,500.
A variety of other deductions can also apply depending on your tax situation before determining your AGI, regardless of your choice between standard or itemized deductions.
How tax credits work
A tax credit is applied after your taxes owed are calculated. Nonrefundable credits can bring your bill to $0 but won’t increase your refund beyond that; refundable credits both will lower your tax bill to $0 and can also increase the amount refunded to you, exceeding what you have already paid throughout the year.
For example, let’s say you had no withholdings this year and based on your income you owe $800 and qualify for a $1,000 credit. In the case of a nonrefundable credit, you would owe $0 in taxes since the value of the credit is greater than the amount owed, but you wouldn’t get the remaining $200 back. In the case of a refundable credit, you would owe nothing and get $200 back as a refund.
Common tax credits and deductions
Below are some common tax credits and deductions:
| Common tax credits | Common tax deductions |
|---|---|
| Child Tax Credit (CTC) for parents of qualifying children under 17 | Mortgage interest deduction on a home loan, claimed if you itemize |
| Earned Income Tax Credit (EITC) for lower- and middle-income workers, with or without kids | Charitable contributions to a qualifying nonprofit, claimed if you itemize |
| American Opportunity Tax Credit (AOTC) for education costs during a student’s first four years of college | Student loan interest deduction allows you to write off student loan interest paid even if you take the standard deduction |
| Child Dependent Care Credit to cover a portion of the child care expenses in a household where both parents work | IRA Deductions for contributions made to a traditional IRA |
| Saver’s Credit for individuals who contributed to qualifying retirement accounts, but has a lower phase out range for levels of income | Business Deductions for self-employed individuals you can deduct qualifying necessary and ordinary business expenses |
