Both tax credits and tax deductions can reduce your tax bill, but in different ways. Tax credits directly reduce the amount of tax you owe the IRS. Tax deductions reduce your taxable income so you're taxed on less.
You can claim both credits and deductions on your tax return if you meet the qualifications for each. Learn 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|
|Directly reduce the amount of tax you owe the IRS||Reduce 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|
|Allow you to claim tax deductions as well||Require that you choose the standard deduction for your filing status or itemize deductions because you can't do both.|
How Credits and Deductions Work
Tax credits subtract directly from what you owe the IRS. They're treated just as though you made a payment to the IRS. Tax credits come in two forms: refundable and nonrefundable. Refundable credits are better, but most are nonrefundable.
Tax deductions are considered less valuable than credits 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, then there are itemized deductions.
You can't itemize if you claim the standard deduction. It's an either/or decision.
Let's say you finish your tax return and you owe the IRS $1,000. Then 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 left over.
The IRS will keep that $1,000 if the credit you claimed was nonrefundable. You'd gain no benefit from the tax credit if you didn't owe any money to the IRS because there would be no tax bill for it to eliminate. But the government would send you the remaining $1,000 if the tax credit was refundable.
As for tax deductions, you would be taxed on only $50,000 of your income if you earned $55,000 last year and you qualified for and claimed $5,000 in tax deductions.
Types of Tax Credits
Some of the most 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)
- Saver's Credit (for contributions made to retirement accounts)
This list is not inclusive. Other less commonly claimed tax credits may apply to you as well. You can find a full list of available 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 for it if your income is less than a certain limit. You won't qualify if you don't earn any income at all, either. Having earned income is required, as the name of the credit suggests.
Child and Dependent Care Credit
The Child and Dependent Care Credit reimburses taxpayers who have paid expenses for the care of qualifying dependents so they could work or look for employment. Adult dependents must be physically or mentally disabled and unable to care for themselves. Child dependents must be under age 13, or disabled and incapable of self care if they're 13 or older.
The credit normally works out to a percentage of up to $3,000 in expenses for the care of one dependent or up to $6,000 for two or more dependents. The percentage you can claim decreases as your income rises.
But the American Rescue Plan Act significantly improved these rules when it was signed into law in March 2021 to provide relief from the impact of the coronavirus pandemic. Unfortunately, the changes are in place for only one year. The expense limits are increased to $8,000 and $16,000 respectively for the 2021 tax year, the tax return you'd file in 2022. The act also increases the maximum percentage from 35% to 50% for one year. It makes the credit refundable.
Child Tax Credit
The Child Tax Credit applies to each of your child dependents who are under the age of 17 as of Dec. 31, the last day of the tax year. The child must live with you for at least half the year. They can't have paid for more than half of their own support, such as in the case of a teenager who works and has income. Numerous other rules apply as well.
The Child Tax Credit allowed you to claim up to $2,000 for each qualifying child you had in tax year 2020 and this is the limit again in tax year 2022. But the American Rescue Plan Act updated this credit for tax year 2021 as well. The age limit was increased to age 17 by the last day of the year. The credit is worth up to $3,000 for children ages 6 through 17 for 2021, and up to $3,600 for children who are under age 6.
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). It increases a little each year to keep pace for inflation. These are the standard deductions for 2021 (the tax return you'd file in 2022) and for tax year 2022.
|Filing Status||Tax Year 2021||Tax Year 2022|
|Head of Household||$18,800||$19,400|
|Married Filing Jointly||$25,100||$25,900|
|Married Filing Separately||$12,550||$12,950|
You should consider itemizing if the itemized deductions you qualify to claim exceed the amount of your standard deduction for your filing status. Itemizing allows you to deduct certain expenses you paid during the tax year, subject to a variety of qualifying limits and rules. You must list these expenses on Schedule A and submit the schedule with your tax return when you file it.
The actual dollar value of these deductions can vary for different taxpayers depending on their income because deductions can only subtract from your taxable income, which determines your top tax bracket. Tax bracket percentages increase with the amount you earn. So a total of $20,000 in deductions would have a value of just $2,400 for someone in the 12% tax bracket (12% of $20,000), but it would create a savings of $7,000 for someone in the 35% bracket (35% of $20,000).
Some commonly claimed itemized deductions include:
- Charitable contributions
- Medical and dental expenses
- Home mortgage interest
- State and local tax deduction limit
Medical and dental expenses are only deductible to the extent that they exceed 7.5% of your adjusted gross income (AGI) as of tax year 2021. The mortgage interest deduction is limited to the interest paid on the first $750,000 of mortgages that are 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.
There's one other type of tax deduction you can claim in addition to either itemizing or claiming the standard deduction. The IRS also offers adjustments to income, commonly referred to as above-the-line deductions. They reduce your adjusted gross income (AGI). They're subtracted before the line that determines your AGI on 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.
The Tax Cuts and Jobs Act of 2017 changed the rules significantly for the alimony deduction. Alimony used to be tax deductible for the payor, and it was taxable income to the receiving spouse. This changed effective Jan. 1, 2019.
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, because credits directly subtract from what you owe the IRS, dollar for dollar. A tax deduction can only reduce your taxable income. It's only worth a percentage of your tax dollar equal to the percentage of your highest tax bracket. But here's some good news: You don't have to choose between the two. You can claim both.
You can claim either the standard deduction or itemize your deductions if itemizing saves you more money. Then you can also claim any tax credits for which you're eligible.
Ask a tax professional if you're not sure what tax credits you might be eligible to claim. Some types of tax software, such as TurboTax, will help you determine what you qualify for as well.
- Tax credits are dollar amounts that subtract directly from 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.
- You can claim both deductions and credits, but you must choose between itemizing deductions or claiming the standard deduction. You can't do both.
Tax Policy Center. "What Are Tax Credits and How Do They Differ From Tax Deductions?"
Congress.gov. "H.R. 1319—American Rescue Plan Act of 2021."