Tax Credit vs. Deduction: What’s the Difference?

You may have made a list and checked it twice during the holiday season, but there is another important list to make in the new year that could give you one of the very best gifts of all: a lower tax bill.

Tax deductions and tax credits are ways to whittle down what you owe to Uncle Sam. Both can lower your tax bill but do so in different ways: While tax deductions reduce the amount of your income subject to tax, tax credits reduce your tax liability directly. Each credit and deduction also has unique eligibility requirements including, for some, income thresholds.

To catch the best possible break on your tax bill, it’s important to remember that changes in your life can change what you can claim.

“It’s important as you go through life and have kids, pay for education, put up solar—you need to take the time to dig in and find ways to take advantage of the tax code,” says Roshan Weeramantry, a partner with Helium Advisors, a tax and wealth planning firm in Berkeley, Calif. He adds that both deductions and credits have benefits, but understanding how they work is important to getting the most out of those that apply to you.

What is a tax deduction?

A tax deduction reduces your taxable income, which can reduce the tax you owe. For instance, for 2023 individual taxpayers can take the standard deduction—a deduction to which all taxpayers are entitled—and reduce their taxable income by $13,850. If you earned $65,000, the standard deduction would knock the amount you pay taxes on down to $51,150—resulting in a saving of $3,047 for a single filer

Tax deductions come in two types: above-the-line and below-the-line.

Above-the-line deductions

Above-the-line deductions get subtracted from your income before your adjusted gross income is calculated. These deductions can be used without having to itemize (more on that below) and include:

• Student loan interest, which includes up to $2,500 of interest paid on both federal and private student loans
• Before-tax retirement account contributions, such as those made to a traditional IRA or 401(k)
• Health-savings account or flexible-spending account contributions
• Capital losses

While these deductions are popular, not all taxpayers qualify. For example, single filers who earn more than $90,000—or joint filers with earnings about $185,000—aren’t eligible to take the student-interest deduction.

Below-the-line deductions

Below-the-line deductions get deducted from your AGI to establish your taxable income. The standard deduction is the below-the-line deduction most people take. However, some taxpayers opt to itemize their deductions for a larger tax break. Potential below-the-line deductions you can take (subject to limits) when itemizing include:

• Mortgage interest
• Medical expenses that exceed 7.5% of your AGI
• Charitable contributions
• Gambling losses
• State and local taxes

If you’re considering itemizing to get more deductions, take caution and run the numbers. Your best bet will always be taking the below-the-line deduction—standard or itemized—that nets you the biggest savings.

What is a tax credit?

A tax credit is a dollar-for-dollar reduction to the tax you owe. For example, if your tax liability was $2,500 and you can claim a tax credit of $2,000, that would reduce your tax bill to $500.

“When you think about credits, just ask, ‘What did I buy this year?’” says Billy Vogel, founder of Fundamental Wealth Designs, a retirement and tax planning firm based in Stillwater, Minn.

For instance, some newer tax credits reward people for purchasing items that increase their home’s energy efficiency. Gather invoices for solar installation, eligible electric vehicle purchases or that new air conditioner you had installed and have them ready to go. Many tax credits must be claimed on your return for the year you made the purchase or completed the installation.

If you’ve been having tax withheld from your paycheck (or making estimated tax payments), it’s possible that credits could translate to a refund. However, credits come in three forms: refundable, partially refundable and nonrefundable, which refer to whether the credit can lead to getting more money back than you paid in taxes come refund time.

Refundable tax credits

If a refundable credit you’re claiming is worth more than your tax bill, you get the full difference back as part of your tax refund. In other words, with a refundable tax credit, it is possible to get more money back than you owed in taxes.

One of the best-known refundable credits is the earned-income tax credit. During the 2022 tax year, 31 million Americans received $64 billion from the EITC, according to Internal Revenue Service data. This averaged out to just over $2,000 per eligible taxpayer. So a taxpayer who was eligible for the EITC and otherwise owed $800 in taxes in 2022, would receive $1,200.

Partially-refundable tax credits

If your tax bill is less than a partially-refundable credit, on the other hand, you only get a portion of the difference back. The American Opportunity Tax Credit, for example, lets eligible students or their parents take a credit of $2,500 a year. However, if your tax bill was smaller than your credit, the IRS only allows you to keep up to 40% of the overage. So if you claimed the full $2,500 and your tax bill was $1,000 you could get $600 back, or 40% of $1,500.

Nonrefundable tax credits

Finally, a nonrefundable tax credit can lower your tax bill but cannot add to your refund. If claiming one puts your tax bill in the negative, your tax bill would simply be reduced to zero. The widely-claimed Child Tax Credit is a nonrefundable credit.

What’s better—a tax deduction or a tax credit?

There’s no choice to be made: You can take whichever tax deductions and credits for which you meet the qualifications. The trick is knowing which ones apply to your life and income.

Let’s say your AGI is $60,000 and you’re eligible for a $5,000 tax deduction and a $5,000 tax credit. Taking both the deduction and credit doesn’t give you $10,000 off your bill. Instead, your taxable income is reduced first, resulting in a lower tax bill. Then, the credit comes in and reduces what you owe dollar-for-dollar.

Clearly, credits and deductions can get complicated. Tax preparation software will ask you questions about potential deductions and credits, determine which ones you qualify for and calculate their impact on your tax bill. If you’d prefer a human helping hand, consider seeking out a tax pro who specializes in tax planning and not just prep.

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