When it comes to paying taxes, tax credits and tax deductions each work a little differently. Tax credits reduce the amount you owe to the IRS, and tax deductions reduce your taxable income.
You can claim both credits and deductions on your tax return, provided that you meet the qualifications for each. Learn how tax credits and deductions vary, as well as what it takes to meet the qualifying rules for these two tax benefits.
What’s the Difference Between Tax Credits and Tax Deductions?
|Tax Credits||Tax Deductions|
|Reduces the amount of tax you owe the IRS||Reduces your taxable income|
|Can be refundable, resulting in the IRS sending you money||Won’t result in cash back unless they reduce your income to the point where you overpaid through withholding or estimated tax payments|
|You can claim multiple tax credits you are eligible for||You must make a choice between claiming the standard deduction for your filing status or itemizing your deductions|
How They Work
Tax credits subtract directly from what you owe in taxes, reducing the total amount you pay to the IRS. When you qualify for a tax credit, the function is the same as if you are making a payment to the IRS.
Tax credits come in two forms: refundable and nonrefundable. Unfortunately, most credits are nonrefundable.
Tax deductions are considered to be less valuable because they can only reduce the amount of income you’re taxed on. There are two types of deductions, just as there are two types of tax credits. There’s the standard deduction, and then there are itemized deductions.
You can’t itemize if you claim the standard deduction. It’s an either/or decision.
Examples of Tax Credits and Deductions
To understand more about how tax credits and tax deductions work, consider these examples.
Tax credit example: Let's say you owe the IRS $1,000 when you finish preparing your tax return. Before paying that tax bill, you realize that you can claim a tax credit worth $2,000. That tax credit would cover your $1,000 tax bill, and you’d have $1,000 of the credit left.
However, the IRS would keep that $1,000 if the credit you claimed was nonrefundable. And if you didn’t owe any money to the IRS after preparing your return, you’d gain no benefit from the tax credit since there’s no tax bill for it to eliminate.
If the credit was refundable, however, the government would send you the $1,000 remaining from the tax credit.
Tax deduction example: Let’s say you earned $55,000 in gross income last year. If you qualified for and claimed $5,000 in tax deductions, you would be taxed on only $50,000 of your income.
Types of Tax Credits
Some of the most popular tax credits include the following:
- Adoption Credit
- American Opportunity Credit (for education expenses)
- Earned Income Tax Credit
- Child Tax Credit
- Child and Dependent Care Credit
- Credit for the Elderly or Disabled
- Lifetime Learning Credit (for education expenses)
- Credit for Other Dependents (for dependents who don’t meet the age requirements for the Child Tax Credit)
- Premium Tax Credit (for health insurance purchased in compliance with the Affordable Care Act)
- Recovery Rebate Credit (for 2020 stimulus payments that you qualified for but did not receive)
- Saver’s Credit (for contributions made to retirement accounts)
This list is not exhaustive. Some other, less commonly claimed tax credits may be applicable for you as well. You can find a list of credits and deductions on the IRS website.
Earned Income Tax Credit
According to the Tax Policy Center, the Earned Income Tax Credit (EITC) is the most commonly claimed tax credit. It’s designed to put money back into the pockets of low- to moderate-income taxpayers. The EITC is refundable, but you can only qualify if your income is not above the income requirements. Nor will you qualify if you don’t earn anything at all—having earned income is required, as the name suggests. The IRS has a tool you can use to see if you qualify for the EITC.
Child and Dependent Care Credit
The Child and Dependent Care Credit reimburses taxpayers who have paid expenses for care of qualifying dependents, thus enabling them to work or look for employment. Adult dependents must be physically or mentally disabled and unable to care for themselves, while child dependents must be under age 13 or, if older, disabled.
Typically, the credit works out to a percentage of up to $3,000 in expenses for the care for one dependent or $6,000 for two or more dependents. As your income rises, the percentage you can claim decreases.
But the American Rescue Plan Act—signed into law in March 2021 to provide relief from the impact of the coronavirus pandemic—significantly improved these rules. The expense limits are $8,000 and $16,000, respectively, for the 2021 tax year. The act also increases the maximum percentage from 35% to 50% for one year and makes the credit refundable.
Child Tax Credit
The Child Tax Credit applies for each child dependent who is under the age of 17 by the last day of the tax year, December 31. The child must live with you for at least half the year, and they can’t have paid for more than half of their own support, such as in the case of a teenager who works. Numerous other rules also apply.
The Child Tax Credit allowed you to claim up to $2,000 for each qualifying child you had in tax year 2020. But thanks to the American Rescue Plan Act, this credit was updated for tax year 2021. The age limit has been increased, now enabling those who are 17 years old by the last day of the tax year to qualify for the credit. The credit is now worth up to $3,000 for children ages six through 17 and up to $3,600 for children who are under age six.
Types of Tax Deductions
While there aren't as many types of tax deductions as there are tax credits, there are still several different types to be aware of.
The Standard Deduction
The amount of the standard deduction is based on your age, income, and filing status—single, head of household, married filing separately, married filing jointly, or qualifying widow(er).
The standard deductions for tax years 2020 and 2021 are outlined in the table below.
|Filing Status||Tax Year 2020||Tax Year 2021|
|Head of Household||$18,650||$18,800|
|Married Filing Jointly||$24,800||$25,100|
|Married Filing Separately||$12,400||$12,550|
These amounts increase a bit annually because they’re adjusted for inflation.
Not everyone qualifies for the standard deduction. The IRS Interactive Tax Assistant can help you determine if you can or can’t use the standard deduction.
If your allowable itemized deductions come out to be greater than your standard deduction, or if you don’t qualify for the standard deduction, you should itemize. This option allows you to deduct certain expenses you paid during the tax year from your income, subject to a variety of qualifying limits and rules. You must list these expenses on Schedule A and submit it with your tax return.
The dollar value of deductions can vary for different taxpayers because, when itemizing, you are subtracting from taxable income, and your taxable income determines your top tax bracket. For example, $20,000 in deductions would have a value of just $2,400 for someone in the 12% tax bracket, but it would be worth $7,000 for someone in the 35% bracket. Tax bracket percentages increase with the amount you earn.
Some commonly claimed itemized deductions include:
- Charitable contributions
- Medical and dental expenses
- Home mortgage interest
- State and local tax deduction limit
Itemized deductions also come with a host of rules. Medical and dental expenses are only deductible to the extent that they exceed 7.5% of your adjusted gross income (AGI) for tax year 2021, for example. In the case of the mortgage interest deduction, it’s limited to the interest paid on the first $750,000 for mortgages taken out after December 16, 2017; this limit drops to $375,000 if you’re married and filing a separate return.
This is not a complete list of all itemized deductions that are available. You can find more itemized deductions for individuals on the IRS website.
"Above the Line" Deductions
There’s one other type of tax deduction you can claim in addition to either itemizing or claiming the standard deduction. These are adjustments to income, commonly referred to as “above the line” deductions. Above-the-line deductions, which reduce your adjusted gross income (AGI), earn their name because they come before the line that determines AGI on tax form 1040.
Above-the-line deductions include but aren’t limited to:
- Alimony paid prior to tax year 2019
- Contributions to health savings accounts (HSAs)
- Contributions to individual retirement accounts (IRAs)
- Educator expenses paid by qualifying teachers
- Student loan interest paid
Claiming these deductions requires that you complete and submit Schedule 1 with your tax return.
Which Is Right for You?
Conventional wisdom says you should claim the tax credit if you have a choice between that or a tax deduction. Here’s why: Credits directly subtract from what you owe the IRS, dollar for dollar, while a tax deduction can subtract only from your taxable income. It’s worth just a percentage of your tax dollar equal to the percentage of your highest tax bracket.
But here's the good news: You won't be forced to choose between the two. With tax deductions, you can either claim a standard deduction or itemize any deductions if that saves you more money. And at the same time, you can claim any tax credits you're eligible for.
If you're not sure which tax credits you can claim, ask your tax professional. Keep in mind that some types of tax software, such as TurboTax, may help you automatically claim tax credits.
The Bottom Line
Tax credits are dollar amounts that directly subtract from your tax liability—what you owe the IRS when you complete your tax return.
On the other hand, tax deductions subtract from your taxable income, potentially bringing you down into a lower tax bracket. Above-the-line deductions reduce your adjusted gross income so you can qualify for more credits and deductions.
Both tax credits and tax deductions can help you catch a break when it comes to paying taxes.