Tax Credits vs. Deductions: What to Know Before You File

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.

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 preparation software can help you understand some of the intricacies, but here we'll give you a high-level overview.

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 rate, 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:

• Earned Income Tax Credit (EITC) — Designed for low- to moderate-income workers, especially those with children, this credit offers up to $7,430 (for tax year 2023) 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 2023 tax year.

• Adoption Credit: You can receive a maximum credit of up to $15,950 per eligible child adopted in 2023, to cover qualified adoption expenses.

• Child Tax Credit: If you have a qualifying child under the age of 17, you could receive a credit of up to $2,000 per child for the 2023 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 or other dependent to offset the cost of care expenses.  
  

• Lifetime Learning Credit (LLC): This credit is worth up to $2,000 for eligible, enrolled students who meet income requirements for the 2023 tax year.

There are many other types of tax credits available to individuals and married couples. Some are intended for homeowners, students, or the elderly, while some credits are even designed for those who save using retirement accounts like an IRA.

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 for a single filer. Not accounting for any tax credits or deductions, this would equate to a basic income tax liability of $12,117.

With an eligible $5,000 tax deduction, your calculated amount of income would drop to $70,000. Thanks to that same 22% tax bracket, this would bring your new income tax liability down to only $11,017.

So while your tax deduction was for $5,000, your actual out-of-pocket savings would be $1,100.

Note that this example does not account for FICA taxes or the standard federal tax deduction. 

Two options for tax deductions

Regarding tax deductions, filers have two options: 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.

The standard deduction for the 2023 tax year ranges from $13,850 to $27,700, 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	2023 standard deduction	2024 standard deduction
Single	$13,850	$14,600
Head of Household	$20,800	$21,900
Married Filing Separately	$13,850	$14,600
Married Filing Jointly	$27,700	$29,200

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 (note that not all charitable donations qualify)
• Property taxes
• Home mortgage interest
• Sales tax
• Gambling losses
• Moving expenses
• Contributions to a health savings account
• Business expenses (such as if you're self-employed)

Yes, itemizing deductions typically means more work. You’ll need to save receipts, track 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

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!