Conventional wisdom says that you should claim the tax credit if you have a choice between that or a tax deduction. Here’s why: Credits subtract directly from what you owe the IRS, dollar for dollar, while a tax deduction can only subtract from your taxable income. It’s worth just a percentage of your tax dollar equal to the percentage of your highest tax bracket.
Fortunately, the Internal Revenue Code doesn’t force you to make the choice. 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.
What Are Tax Credits?
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. And unfortunately, most credits are nonrefundable.
For example, say you owe the IRS $1,000 when you finish preparing your tax return. Before paying that tax bill, you realize 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, though, the government would send you the $1,000 remaining from the tax credit.
Some of the more popular tax credits include:
- 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
The Earned Income Tax Credit (EITC) is the most commonly claimed tax credit, according to the Tax Policy Center. 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 it 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, Dec. 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 apply, as well.
The Child Tax Credit allows you to claim up to $2,000 for each qualifying child you have 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 who are 6 through 17 years old, and up to $3,600 for children who are under age 6.
What Are Tax Deductions?
Tax deductions are considered to be less valuable tax breaks because they can only reduce the amount of income you’re taxed on. For example, let’s say that you earned $55,000 in gross income last year. If you qualified for and claimed $5,000 in tax deductions, you would only be taxed on $50,000 of income.
There are two types of deductions, just as there are two types of tax credits. There’s the standard deduction, and then there are also itemized deductions.
You can’t itemize if you claim the standard deduction. It’s an either/or decision.
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 2020, 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 Dec. 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.
Tax Credits vs. 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 both credits and deductions that you qualify for||You must make a choice between claiming the standard deduction for your filing status or itemizing your deductions|
What Are “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
The Bottom Line
Tax credits are dollar amounts that subtract directly from your tax liability—what you owe the IRS when you complete your tax return. 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. Whichever option you qualify for, you are bound to catch a tax break.