There are few things in life as certain as taxes, and Uncle Sam is happy to remind you of that each April. Just because you can’t avoid paying taxes, though, doesn’t mean that you can’t optimize your tax bill to save as much as you can.
Whether you aim to get a refund check each year or are simply trying to reduce your overall tax liability, there are many strategies to consider. However, comparing tax credits versus tax deductions — and understanding the difference between the two — is one very simple way to lower the amount you’ll owe. Working with an accountant or some of the best tax software can help you understand some of the intricacies, but if you don't have access to either, we can help.
Today, we are going to talk about tax credits vs. deductions, and what each means when it comes to your IRS bill each spring. Knowing the difference can help you understand how to manage your money better.
Tax credit vs. deduction: How are they different?
Whether you wait until April 14th to gather W-2s or religiously file quarterly taxes every three months, you are probably interested in sending less of your hard-earned money to the IRS. That’s where tax discounts — in the form of credits and deductions — come into play.
While both tax credits and tax deductions will help to reduce your tax bill, they work in two very different ways. Here’s how they’re defined, according to the IRS:
- A tax credit is a refund that reduces the total amount of tax that you owe upon filing. There are both refundable and nonrefundable tax credits, crediting you either up to or even beyond your total federal income tax burden.
- A tax deduction will reduce your taxable income, which is then used to calculate your taxes owed.
You might be thinking, “Okay, these definitions are great… but what do they actually mean for me and my IRS bill?” So, let’s delve a bit deeper.
What is a tax credit?
At its foundation, a tax credit is an actual IRS bill reduction that lowers your overall calculated tax burden, dollar-for-dollar.
It’s easy to see the impact of tax credits, too: if you owed $1,500 in taxes but were eligible for a $500 tax credit, your IRS bill would simply be reduced to $1,000.
In some cases, a credit can mean getting more money refunded from the IRS than you actually owe in taxes. For example, if you owed $1,500 in taxes but were eligible for a $2,000 refundable tax credit, your IRS tax liability would be wiped out and you’d see the $500 difference back in the form of a tax refund.
Some common tax credits include the:
Earned Income Tax Credit (EITC) — Designed for low- to moderate-income workers, especially those with children, this credit offers up to $6,728 (for tax year 2021) for qualifying taxpayers
Premium Tax Credit — Offered on a sliding scale, based on income limits and local health insurance markets, this provides tax credits toward the healthcare costs of eligible individuals and families.
American Opportunity Tax Credit — This credit for higher education expenses is worth up to $2,500 per qualifying student for the 2021 tax year.
Adoption Credit — You can receive a maximum credit of up to $14,400 per eligible child adopted in 2021, to cover qualified adoption expenses.
Child Tax Credit — If you have a qualifying child under 17, you could receive a credit of up to $2,000 per child for the 2021 tax year.
Child and Dependent Care Credit — While it's similar in name to the Child Tax Credit, this credit offers up to $3,000 per qualifying child to offset the cost of childcare expenses.
Lifetime Learning Credit (LLC) — This credit is worth up to $2,000 for eligible, enrolled students who meet income requirements for the 2021 tax year.
There are many other types of tax credits available to individuals and couples. Some are intended for homeowners, students, or the elderly, while some credits are even designed for those who save for retirement.
It’s important, however, to note that all tax credits come with their own eligibility requirements and guidelines. Plus, many credits are contingent on the adjusted gross income (AGI) of the filer(s), so earning too much can make you ineligible to receive them.
Refundable and non-refundable tax credits
There are two types of tax credits available: refundable and non-refundable.
Refundable tax credits offer taxpayers a refund regardless of their tax liability. This means that if you owe less to the IRS than the credit is worth, it will actually result in a refund for the difference.
On the other hand, a non-refundable tax credit will only reduce your tax burden up to the total amount you owe. So even if your tax credit is worth more than you owe in taxes, you won’t get the excess back in the form of a refund; it will only zero out your tax bill.
What is a tax deduction?
Another way to lower your IRS tax bill is to take advantage of tax deductions. These work a bit differently than tax credits, however, by helping to lower your calculated taxable income.
Your income is used to determine your overall tax liability, calculated as a percentage of your eligible earnings. So, applying deductions to reduce your total taxable income will help to reduce your tax bill, but it will not provide a dollar-for-dollar reduction to your tax burden.
Let’s say that your income was $75,000 this year, putting you in a 22% income tax bracket. Not accounting for any tax credits or other deductions, this would equate to a basic income tax liability of $16,500.
With an eligible $5,000 tax deduction, your calculated income would drop to $70,000. Thanks to that same 22% tax bracket, this would bring your new income tax liability down to only $15,400.
So while your tax deduction was for $5,000, your actual out-of-pocket savings would be $1,100.
Two options for tax deductions
When it comes to tax deductions, filers have two options: either take the standard deduction or itemize deductions. The one that makes the most sense for you will depend on how many eligible deductions you have and which option saves you the most money on your tax bill.
For the 2020 tax year, the standard deduction ranges from $12,400 to $24,800 depending on your tax filing status. You may be able to take an even larger deduction if you’re over the age of 65 or if you’re blind.
|Filing status||2020 standard deduction||2021 standard deduction|
|Head of Household||$18,650||$18,800|
|Married Filing Separately||$12,400||$12,550|
|Married Filing Jointly||$24,800||$25,100|
Taking the standard deduction is often a good choice for filers, especially those who have a pretty simple income tax return. It offers an easy way to reduce your tax liability without having to worry about calculating expenses or saving receipts.
On the other hand, there are a variety of itemized deductions for which you may qualify, which could potentially reduce your tax burden even further. These include, but are not limited to, tax-deductible expenses like:
- Charitable contributions
- Property taxes
- Home mortgage interest
- Sales tax
- Gambling losses
- Moving expenses
- Contributions to a health savings account
Yes, itemizing deductions typically means more work. You’ll need to save receipts, keep track of expenses, and think about eligible expenses.
However, if you are not eligible to use the standard deduction for any reason — or if your allowable itemized deductions throughout the year add up to a greater amount — it’s probably in your best interests to itemize at tax time.
FAQs about tax credits vs. deductions
What's better, a tax credit or a tax deduction?
While both tax credits and tax deductions can give you tax breaks, they do so in different ways. A tax credit is often considered a better option because it can lower your overall calculated tax burden, dollar-for-dollar. Tax deductions may result in a lower tax bill and a potentially higher return, but they do not reduce your tax burden dollar-for-dollar like a tax credit does.
Are medical expenses and dental expenses tax-deductible?
Medical expenses and dental expenses may be tax-deductible under certain circumstances. If your total medical or dental expenses exceed 7.5% of your gross income, you may be able to deduct them from your taxes. However, the IRS has set parameters around which expenses are considered tax-deductible. For more information, consult the IRS website.
Is student loan interest tax-deductible?
Student loan interest could be tax-deductible, provided that you have a qualifying student loan and you meet certain income requirements. The student loan interest deduction allows you to deduct up to $2,500 if your MAGI is lower than $70,000 as a single filer or head of household. Joint married filers can also deduct up to $2,500, provided that their MAGI is lower than $140,000. If you have questions about whether this deduction applies to your tax situation, consult the IRS website.
Tax credit vs. deduction: The final word
No one enjoys paying taxes, but they are a necessary part of life. Thanks to tax credits and deductions, though, you can reduce your overall tax liability and keep more of that money in your pocket.
Credits impact your tax bill dollar-for-dollar while deductions lower your calculated income. In the end, though, both do a great job of reducing Uncle Sam’s cut... and saving you money!