Tax deductions and credits serve the same purpose − to reduce the amount of a taxpayer's tax owed. However, the way that each serves this purpose is different.
Deductions reduce the amount of a taxpayer’s taxable income. To put it another way, deductions ultimately reduce a taxpayer’s tax rate. Some examples of deductions are traditional IRA contributions, educator expenses, student loan interest paid, and health savings account contributions. Itemized deductions are other expenses that reduce a person’s taxable income. Itemized deductions include medical expenses paid, mortgage interest paid, property taxes paid, state and local income taxes paid, and charitable contributions made. Although there are exceptions, most taxpayers are eligible for the standard deduction, even if they do not have any other deductions. The amount of the standard deduction depends on your filing status and tax year.
Here is an example of how a tax deduction might benefit you:
If you are single, under age 65, and in 2018 your wages were $60,000 (your only income) and you did not have any deductions, you should have been able to claim the standard deduction, which was $12,000 for a single taxpayer in 2018. Your taxable income ($60,000 minus $12,000) would have been $48,000, and your tax liability would have been $6,505.
Now, taking into consideration the same example, suppose you had educator expenses of $250, a Traditional IRA contribution deduction of $5,000, and a student loan interest deduction of $2,500, for a total of $7,750. Your taxable income would have been $40,250 (wages of $60,000 minus deductions of $7,750 and $12,000 in standard deduction.). The tax on $40,250 would have been $4,800. These deductions would have saved you $1,705 in tax ($6,505 minus $4,800)! Furthermore, a contribution to an IRA account is one of the great ways to save for retirement.
On the other hand, tax credits reduce a taxpayer’s tax liability. Credits come into play after a person’s tax is calculated on the return.
And here is how a tax credit might benefit you:
If your tax liability is $3,000 and you are entitled to $2,500 in tax credits, your tax liability will be reduced to $500. Therefore, a $2,500 tax credit resulted in $2,500 less tax owed.
As you can see in the above examples, a tax credit is a dollar-for-dollar reduction in tax. On the other hand, a tax deduction will reduce your taxable income; the amount you save in tax is dependent upon your tax bracket.