What Is the Difference Between a Tax Credit and a Tax Deduction?

When you're getting ready to do your taxes, the concepts of tax credits and tax deductions can be very appealing to taxpayers. This is due to the fact that both are mechanisms to reduce the amount of tax owed to the government. Although there's good reason to be enthusiastic about both, it's crucial to grasp the basic distinction between these two terms.

What Are Tax Credits?

Simply put, tax credits are reductions on the amount of actual tax owed. Tax credits in no way affect your tax bracket or taxable income. Instead, think of these as reductions that come after the fact - i.e. after you’ve determined how much you owe to the government. There are a few common types of tax credits that can be given based on your income level, whether or not you have children, if you’re a college student and more. These common credits include:

• Child Tax Credit
• Child and Dependent Care Credit
• Lifetime Learning Credit
• Adoption Credit
• Earned Income Tax Credit
• Residential Energy Tax Credit

Tax credits are typically either refundable or non-refundable. Depending on which type of credit it is, this will affect how much you’ll receive back on your tax refund.

Refundable Tax Credits

Refundable tax credits enable you to receive a refund for any unused portion of the credit. Consider a situation where your tax bill is $900, and you qualify for a child tax credit of $2,000. In this case, not only does the credit fully offset the $900 you owe, but you will also get a refund of the surplus $1,100.

Non-Refundable Tax Credits

On the other hand, non-refundable tax credits are limited to the amount of taxes you are liable for and do not exceed that limit. In scenarios where the credit exceeds the tax owed, the surplus is not refunded. For instance, if your tax liability is $900 and you have a non-refundable credit of $2,000, the credit will offset the $900 owed, but the remaining $1,100 of the credit is not reimbursed to you.

What Are Tax Deductions?

Tax deductions are used to reduce the amount of income that’s eligible to be taxed. By reducing this amount, your income may fall into a lesser tax bracket, meaning you’re subject to pay a lesser tax percentage. There are typically two types of tax deductions: itemized deductions and above-the-line deductions.

Itemized Deductions

You can use itemized deductions to help lower your taxable income. Common types of itemized deductions include:

• Charitable donations
• Medical expenses
• Property taxes
• Mortgage interest

While people are welcome to add each deduction up separately on their taxes (i.e. itemize them), most will opt for the standard deduction set by the IRS. For the 2023 income tax year, these are the standard deduction amounts:

• Single or married but filing separately: $13,850
• Married and filing jointly or qualifying widow(er): $27,700
• Head of household: $20,8001

It is common to use a standard deduction because, in most cases, an itemized amount won’t exceed the IRS’s standard deduction rates.

Above-The-Line Deductions

Above-the-line deductions are used to reduce your adjusted gross income (AGI), which can qualify you for certain itemized deductions and tax credits. Your adjusted gross income is determined by subtracting above-the-line deductions from your gross income. This lower AGI can then allow you to claim important tax credits or deductions that may be dependent on income level. Common above-the-line deductions include:

• Alimony paid
• Educator expenses
• Student loan interest
• Deductible IRA contributions
• Moving expenses of armed forces members

Tax credits and tax deductions can both greatly benefit taxpayers, especially when they work in tandem. Familiarizing yourself with the difference between these two tax terms gives you a great place to start researching and understanding what deductions and credits you and your spouse may be eligible for in the upcoming tax year.

1. https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2023

This content is developed from sources believed to be providing accurate information. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.