Tax credits and tax deductions are not the same thing: What's the difference, which is better?
If you want to reduce the money you owe the Internal Revenue Service, you need to claim all of the tax deductions and credits that are available to you. Both deductions and credits can have a big effect on reducing your tax bill, but they are definitely not the same – and one is much more valuable than the other.
So what exactly is the difference between tax credits and tax deductions? Read on to find out.
Understanding the difference of tax credits versus tax deductions
Tax deductions save you money by reducing your taxable income. Tax credits save you money by reducing your tax bill on a dollar-for-dollar basis.
The best way to understand this is by looking at an example.
Say you're a single tax filer with $50,000 in taxable income. If you're eligible for an additional $2,000 tax deduction, the deduction would reduce your income from $50,000 to $48,000. The savings would come from not paying taxes on the $2,000 that you were allowed to deduct. Since this is income that would've been taxed in the 22% tax bracket, the deduction would save you $440.
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If you'd instead received a $2,000 credit, though, the math works very differently. Your credit doesn't reduce your income – it reduces your tax bill directly. If you would have owed $6,790 in taxes on your $50,000 in income, but you get a $2,000 credit, your tax bill goes down to $4,790. You've saved $2,000, so your credit was worth $1,560 more than the deduction.
Some credits are refundable
There's also another benefit to tax credits versus deductions. Deductions can reduce your taxable income, but they can't bring it below $0. If you have $10,000 in taxable income and an $11,000 deduction, you could reduce your taxable income to $0, but you wouldn't get any benefit from that that extra $1,000 you had left to deduct.
Some credits, on the other hand, are refundable. This isn't the case for all credits. And some of them, like the Child Tax Credit, are only partly refundable. But when a credit is fully or partly refundable, it's possible you could actually get more money back than you owed in taxes. If you have a total IRS bill of $1,000 and get a $1,400 refundable credit, you could actually get back $400 more than you paid in.
There are two options for claiming deductions
When it comes to tax credits, you have to meet certain requirements to qualify. Deductions, on the other hand, work a little differently. See, everyone has the option to claim the "standard deduction," which is a deduction for a set amount based on your filing status. You don't have to do anything to claim it.
You also have the option to itemize deductions instead, which would mean claiming deductions for specific expenses you incurred, such as mortgage interest payments you made. Most people just claim the standard deduction, although you'd want to itemize if doing so would provide more savings.
Make sure you claim all of your deductions and credits
When you file your taxes, it's important to claim all of the tax breaks that you're eligible for. Check out our guides to common deductions and credits so you can find out the best way to maximize your tax savings.
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