Tax Credit vs Tax Deduction | What's the difference?

June 11, 2024 by Carolyn Richardson, EA, MBA
Cash and coins spread out on a table

When it comes to your income tax return, not everything is created equal. While a dollar may be a dollar, where those dollars go and what they do for you may create vastly different results on your return, changing a balance due to a refund. Such is the case when it comes to tax deductions and tax credits.

Both a tax deduction and a tax credit serve the same purpose – to reduce the amount you may owe on your return, and possibly increase your refund. But how they get there is different.

Generally, a tax credit is more beneficial for you than a tax deduction because a tax credit will reduce your tax liability (or increase your refund) by $1 for every $1 of credit. Tax deductions, on the other hand, will reduce your taxable income instead, so the amount of tax reduction achieved will depend on your tax bracket. For example, if you are in the 25% tax bracket, that dollar will only produce 25 cents of tax savings.
 

Tax Credit Pros and Cons


You may qualify for a few credits without even trying hard to get them, like the foreign tax credit. This is commonly available if you have a taxable brokerage account and invest in mutual funds or ETFs that invest in foreign companies. If your income is low enough but you still contribute to your 401(k) at work, you may qualify for the Retirement Saver’s Credit. Most tax software will calculate these automatically if you qualify.

You might be thinking that this is a “no brainer” and you’d much rather have a tax credit, right? Not so fast – most tax credits are available only under a limited set of circumstances and certain taxpayers, so you may not qualify for any tax credits. And some tax credits, since they are more generous in their tax reductions, are frequently the target of closer scrutiny by the IRS. This is certainly the case in the most common of credits, such as the Child Tax Credit or the Earned Income Credit, but these credits aren’t available higher earners or children who are 17 or older, unless they are permanently disabled. And while your tax software might include these on your return, keep in mind that the tax software is relying on you to answer questions correctly regarding your qualifications for these credits. Even a slightly different answer can change the result and get you into hot water with the IRS later.

For example, you may think of your girlfriend’s child as your own child, particularly if you are living together and you are providing all of the support for both of them. It’s not an unusual situation, and we frequently hear from clients who say, “I think of Billy as my own son, and I’ve been raising him since he was a baby.” If you tell your software that this child is YOUR child, even though there is no biological link between the two of you, the software will give you a child tax credit for the child. But this would be incorrect, as you cannot claim your girlfriend’s child as your own child, even if she doesn’t file a tax return. On the other hand, if you and your girlfriend married, you would be able to claim little Billy as your child. That small difference in the circumstances can result in an additional $2,000 in tax reductions, the amount of the Child Tax Credit. And you don’t even have to owe any taxes to get some benefit, as a portion of the Child Tax Credit is refundable, meaning you can receive more back as a refund than you paid! Great deal, right? Except that the IRS frequently questions who is claiming the Child Tax Credit, and more than one person may be claiming that child (such as your girlfriend, the child’s actual biological father, or some other person). If you cannot show you are entitled to that credit, you won’t receive it.

Another issue with many credits is they are reduced or eliminated by your income. For example, if you install solar panels on your home, you can claim a tax credit equivalent to 30% of the system cost on your tax return. That can result in a HUGE tax credit. This credit is nonrefundable; however, so you may not receive a full benefit from it. And while the credit for purchasing an electric vehicle is still as much as $7,500, recent legislative changes now eliminate the credit for higher income taxpayers.

So, remember, tax credits reduce a taxpayer’s tax liability. Credits come into play after a person’s tax is calculated on the return.
 

Tax Deductions

 

On the other hand, tax deductions reduce your taxable income, which will reduce your tax liability, so the amount you save will depend on your tax bracket. Tax deductions can be a lot easier to claim, as there are more tax deductions than there are tax credits. You do need to qualify for the deduction and spend the money to obtain them, but a lower taxable income will also reduce your tax liability.

Most taxpayers are probably familiar with itemized deductions. While the standard deduction has been raised through 2025 by the Tax Cuts and Jobs Act of 2017 (TCJA), making itemizing less common or beneficial for many taxpayers, itemizing is still an option for many. It’s entirely possible that in 2026, those higher thresholds for the standard deduction may get reduced when the TCJA expires, making itemizing more attractive to more taxpayers. For most taxpayers, though, owning a home will be the key to making itemized deductions worthwhile, since the two major deductions available are home-related in the form of a mortgage interest deduction and a deduction for real property taxes paid. But there are other deductions available as well, such as your state income tax or sales taxes (but keep in mind that these taxes, which include your property tax, are currently limited to a cumulative total deduction of $10,000 through 2025). If you contribute to charity, be it in cash or with noncash donations, those also get added to your itemized deductions. If you’re elderly and retired and your income has lowered while your medical expenses have increased, you may be able to claim a deduction for your medical expenses, if they exceed 7.5% of your adjusted gross income. This could also be the case if you have a more catastrophic health situation that’s not covered by your insurance, such as the out-of-pocket costs of cancer treatments.

If you don’t itemize, what other kinds of deductions can you claim? Tax deductions go beyond itemized deductions. If you are a preschool or primary schoolteacher, you can claim $300 as a deduction for supplies you purchase for your classroom. Paying interest on your student loans? That amount is still deductible, up to $2,500. If you contribute money to a traditional IRA, you can also deduct those contributions, although they may be limited by your income if you or your spouse are otherwise covered by a retirement plan at work. If you’re self-employed, you can also deduct half the cost of your health insurance costs (even if you don’t itemize) and contributions to self-employed retirement plans.

So, a tax deduction reduces your taxable income before the tax is computed, but a lower taxable income will result in a lower tax liability.
 

The Best of Both Worlds – Claiming Both


Keep in mind that there’s almost no overlap between available tax deductions and available tax credits, so just because you claim tax deductions doesn’t make you ineligible for tax credits. You are allowed to legally reduce your tax liability as much as possible by taking every deduction and credit available to you. But as always when it comes to taxes, make sure you keep your documentation in case you wind up in an audit!

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Carolyn Richardson, EA, MBA
Learning Content Managing Editor

 

Carolyn has been in the tax field since 1984, when she went to work at the IRS as a Revenue Agent. Carolyn taught many classes at the IRS on both tax law changes and new hire training. In 1990, she left the IRS for a position at CCH, where she was a developer on both the service bureau software and on the Prosystevm fx tax preparation software for nearly 17 years. After leaving CCH she worked at several Los Angeles-based CPA firms before starting at TaxAudit as an Audit Representative in 2009. Carolyn became the manager of the Education and Research Department in 2011, developing course materials for the company and overseeing the research requests. Currently, she is the Learning Content Managing Editor. 


 

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