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Tax credit vs. tax deduction: What's the difference and which is better?

Yahoo Personal Finance· Getty Images
Updated 5 min read

Saving money by lowering your tax bill is one of the more satisfying endeavors of adulting. But what’s the best way to ensure Uncle Sam issues you a refund check? The secret is in leveraging both tax deductions and tax credits to ease your tax burden.

Before you start stumbling through your tax return, let’s clear up any misconceptions about the differences between a tax credit and a tax deduction and how both work to lower your tax liability and your tax rate in different ways.

Read more: Here are 7 free tax filing options

A tax credit directly reduces the taxes you owe the IRS (Internal Revenue Service) by providing a dollar-for-dollar reduction of your actual tax bill. In the simplest terms, if you owed $2,500 on your tax return but are claiming tax credits of $1,500, your taxes due would instead total $1,000.

Because they are direct credits against your tax bill, tax credits greatly reduce your taxes for a given tax year and help you pay less tax overall.

One key thing to understand is the difference between a refundable credit and a nonrefundable credit. Refundable tax credits reduce your tax liability past zero and can result in being issued a refund check. Nonrefundable tax credits will take your tax bill to zero but won’t trigger a refund. Some tax credits are partially refundable, which usually means one portion of the tax credit is eligible for a refund while the rest is not.

For example, if you have a $1,000 tax bill and claim a $1,200 refundable tax credit, the IRS cuts you a check or issues you a refund of $200. If that same tax credit is nonrefundable, your tax bill would be $0, but you wouldn’t receive a tax refund.

The IRS also has specific qualifications and terms tax credit recipients must meet. These qualifications are related to income, tax filing status, and other criteria.

Tax credits fall into several categories, but here’s a snapshot of the most popular ones that may apply to your financial tax situation.

Two of the most frequently used tax credits are the child tax credit and the earned income tax credit (EITC). The child tax credit lightens your tax load for having a dependent under your care in the United States, and the earned income tax credit is for taxpayers who fall below the poverty line according to filing status. Child and dependent care credits, education credits, and adoption credits also fall into this category.

These credits are exactly what they sound like — tax breaks for those who invest in electric vehicles and other clean vehicles as specified by the IRS.

Read more: Here are the 13 EVs and plug-in hybrids eligible for federal tax credits

Several types of tax credits fall under this umbrella, but the most frequently used is the retirement savings contribution credit — commonly known as the saver’s credit — which credits you for contributions made to your individual retirement account. It’s limited to middle- and low-income earners.

Tax credits available for homeowners include home energy credits for making improvements like adding solar panels and for upgrading appliances and home systems to be more energy efficient.

The IRS offers something called a Premium Tax Credit (PTC), which helps eligible individuals and families cover health insurance premiums purchased through the federal healthcare marketplace.

Instead of taking money off your tax bill, tax deductions reduce your taxable income. How much a tax deduction lowers your tax liability depends on your tax bracket.

Tax deductions can work as either above-the-line deductions or itemized deductions. Above-the-line deductions are applied to your adjusted gross income (AGI) even if you use the standard deduction on your income tax return. Itemized deductions can only be used in place of the standard deduction in calculating the taxes you owe.

One of the biggest decisions taxpayers make is whether to itemize deductions or take the standard deduction. The standard deduction reduces what you owe by subtracting a flat dollar amount from your taxable income according to your filing status. The key is to determine whether the sum total of itemized deductions you qualify for exceeds the standard deduction so you reduce your overall tax liability.

Here are a few deductions and other tax breaks you may be able to claim:

You don’t need to be a tax professional to see how tax credits and deductions might work together for the average taxpayer. Let’s say your income is around $100,000, and you’re married filing jointly. You’d pay around 12% or $8,000 in federal taxes. However, you have two kids, so you receive a $4,000 child tax credit, reducing your tax bill to about $4,000.

This year, you decide to itemize your taxes, and through a combination of deductions for mortgage interest and charitable contributions, you reduce your taxable income to $90,000. Your taxes owed would fall by about $1,000, but you’d still receive the child tax credit of $4,000, lowering your overall tax burden to $3,000.

The good news is that because of how tax preparation works, you don’t necessarily have to choose. While you can’t apply a tax credit and a tax deduction for the same expenses, you can use specific deductions and tax credits to reduce the amount of tax you owe and maximize your deduction amount.

While tax credits are more effective because they apply a dollar-for-dollar credit to the taxes you owe, credits and deductions can add up to significantly reduce your taxable income and lower your marginal tax bracket, which translates into a less expensive tax season even for high-income taxpayers.