Tax deductions and tax credits reduce how much you owe the IRS, but in different ways.
- Tax credit: A tax credit gives you a dollar-for-dollar reduction in your tax bill. For example, if your federal tax bill is $10,000 and you are entitled to a $2,500 tax credit, that credit cuts your tax bill by $2,500 — to $7,500. Tax credits are incentives that governments give for behaviors they want to encourage, such as installing solar panels or adopting a child.
- Tax deduction: A tax deduction is an amount that the government allows you to deduct from your adjusted gross income (AGI), thereby lowering how much of your income you must pay taxes on. The standard deduction is available to all taxpayers. You don’t have to qualify for it but the amount depends on your filing status. Other deductions, such as qualifying medical expenses, must be itemized and have limits.
Types of tax credits
There are three types of tax credits:
- Partially refundable.
Refundable tax credits
Refundable credits are treated as if they were tax payments you made throughout the year, just like the money an employer withholds from your paycheck and sends to the IRS on your behalf.
If a refundable credit is greater than your total tax obligation, the IRS will send you the difference in the form of a tax refund.
Some refundable tax credits include:
- Earned income tax credit.
- Child tax credit.
- American opportunity tax credit.
Nonrefundable tax credits
If a tax credit is greater than your actual tax bill but the credit is nonrefundable, you do not get the difference in the form of a tax refund. For example, if you owe $1,500 in taxes and are eligible for a $2,000 credit, the credit reduces your tax bill to zero, but you do not get a refund for the remaining $500 of your tax credit.
Some nonrefundable tax credits include:
- Adoption tax credit.
- Elderly and disabled tax credit.
- Lifetime learning credit.
Partially refundable tax credits
A partially refundable tax credit can be used to reduce your tax bill to zero and from there, you may be eligible to get a refund on a portion of the remaining credit.
For example, the American opportunity tax credit, designed to help families pay for higher education expenses, is worth up to $2,500 if you are an eligible student or have a dependent who qualifies as an eligible student. If the tax credit is more than the taxes you owe, 40 percent of the leftover amount (up to $1,000) can be issued as a refund.
Example: Tax credit vs. tax deduction
|$5,000 tax deduction||$5,000 tax credit|
|Note: This table is an example, not a complete tax-bill calculation.|
|Adjusted gross income (AGI)||$80,000||$80,000|
|Minus tax deduction||($5,000)|
(married filing jointly)
|Minus tax credit||($5,000)|
|Total tax bill||$9,000||$4,600|
Tax credit or tax deduction: Which one is better?
Any legitimate deduction or credit that will trim your tax bill is a good thing. But tax credits outshine tax deductions because of how much money they can save you, financial experts agree.
“Credits win every time because they are a dollar-for-dollar reduction of your tax bill,” says Megan Brinsfield, CPA and director of financial planning at Motley Fool Wealth Management. “Deductions will reduce your overall income before applying to your tax rate.”
Deborah Todd, a CPA and president and CEO of iCompass Compliance Solutions, agrees that credits are a more valuable way to reduce your taxes. “While any tax deduction is better than no deduction, a tax credit will put more real dollars in your pocket,” she says.
How much a tax deduction saves you will depend largely on your federal income tax bracket. “Deductions reduce what you report as income; the dollar value you receive depends upon your tax rates,” says Justin Pritchard, certified financial planner and founder of Approach Financial Inc., based in Montrose, Colorado.
Deductions reduce your taxable income by the percentage of your highest tax bracket. For example, if you are in the 24 percent tax bracket, a $1,000 deduction will save you $240 (1,000 x 0.24 = 240) on your tax bill.
With deductions, you can take either the standard deduction or you can itemize, but you can’t do both. If itemized expenses, such as medical bills, home mortgage interest and charitable donations, are higher than your standard deduction, you will save more money by itemizing.
If you do itemize your deductions, be sure not to overlook any. Property taxes, for example, are easy to forget because there is no dedicated tax form that a county or local government is required to send you.