A tax deduction reduces your taxable income, potentially lowering the amount of income you can be taxed on. A tax credit directly reduces the amount of tax owed. Tax deductions are based on expenses or contributions, such as mortgage interest or charitable donations. Tax credits are applied after calculating how much you owe in taxes and can provide a dollar-for-dollar reduction.
When you file your federal and state tax returns, you probably look for ways to reduce the amount of money you owe. To maximize your savings, you need to know the difference between a tax credit vs. a deduction. Both affect the amount of tax due, but they do so in different ways. Here’s how to distinguish between the two.
Note: This is for informational purposes only and is not tax advice. Please consult your tax professional to discuss your individual situation.
Defining Tax Credit vs. Tax Deduction
A tax credit is a tax incentive that allows you to subtract the amount of the credit from the amount of tax you owe. For example, if you owe $2,000 in taxes and take a credit worth $1,000, the credit reduces your tax bill to $1,000. The tax credit is a dollar-for-dollar adjustment.
In contrast, a tax deduction is an amount of money deducted from your income. When you take a deduction, it reduces your taxable income by the same amount of money. For example, the standard deduction allows you to deduct $14,600—$29,200 for married couples—from your adjusted gross income.
Here’s the main difference between the two. Tax credits reduce your tax bill directly, as they offset your tax liability. Tax deductions don’t reduce your taxes directly, but they lower your tax bill by reducing the amount of taxable income you have.
Refundable vs. Nonrefundable Tax Credits
Once you understand the difference between a tax credit vs. a deduction, you also need to know the difference between refundable and nonrefundable tax credits. The type of credit you apply makes a big difference in determining the size of your refund.
If you owe less than the amount of a refundable credit, you get the difference back from the IRS or your state revenue agency. Assume you owe $500 and are eligible for a refundable credit worth $1,500. Not only would the credit wipe out your $500 tax bill, but it would also help you qualify for a $1,000 tax refund.
With nonrefundable credits, you don’t get back the difference between the amount of the credit and the amount of tax you owe. In the scenario above, the credit would reduce your tax bill to $0, but you wouldn’t get the extra $1,000 as a refund.
Common Tax Credits and Deductions
Before you prepare your tax return, take time to learn about some of the most common tax credits and deductions for taxpayers in your situation. Many credits and deductions are based on your income, family size, and filing status. You may also qualify for credits and deductions based on college enrollment, self-employment, or charitable donations.
Tax Credits
Earned Income Tax Credit
The EITC is a federal tax credit for filers with low to moderate incomes. To qualify, you must have earned income, which is income you get from working. Dividends, bank interest, and other forms of passive income don’t count as earned income.
You must also earn less than $63,398 annually. The amount of the EITC ranges from $600 to $7,430, depending on how many children you have.
American Opportunity Tax Credit
The American Opportunity Tax Credit is a federal tax credit worth up to $2,500 per year. You may qualify if you have expenses related to your first four years of higher education, such as tuition, textbooks, or course fees.
Additionally, the AOTC is partially refundable. If you owe $0, you can get back 40% of the remaining amount of the credit as a refund. For example, if you owe $0 and are eligible for the $2,500 maximum, you can get a $1,000 refund when you file your return.
To qualify for the AOTC, you must have a modified adjusted gross income of no more than $80,000 per year—$160,000 if you’re married and file a joint tax return.
Lifetime Learning Credit
The Lifetime Learning Credit is also an educational credit, but it’s a little more flexible than the AOTC. To claim this credit, you must meet the following requirements:
- You paid qualified expenses for higher education.
- You paid the expenses for an eligible student enrolled at any college, trade school, university, or other educational institution that meets the requirements to participate in a federal student aid program. This is known as an “eligible institution.”
- The eligible student is you, your spouse, or a dependent claimed on your tax return.
- Your modified adjusted gross income doesn’t exceed $90,000—or $180,000 if you’re married and file a joint tax return. Note that the amount of the credit is gradually reduced if you have a MAGI between $80,000 and $90,000. If you’re married and file a joint tax return, the phaseout starts at $160,000.
This credit is worth up to $2,000 per year, and there’s no limit to the number of times you can claim it.
Child and Dependent Care Credit
The child and dependent care credit reimburses you for some of the expenses you paid for the care of a qualifying individual. If you have a child, they must be under the age of 13 at the time you pay for care. A qualifying individual may also be an adult who’s mentally or physically unable to care for themselves.
The IRS only allows you to claim this credit if you paid for care because you were working or actively looking for work. You can’t claim the credit if you needed child or dependent care for another reason, such as attending school or taking time off to care for an elderly parent.
If you qualify for the credit, the amount you can claim depends on your income. Under the IRS rules, an eligible taxpayer may claim 20% to 35% of their child and dependent care expenses. However, you’re only allowed to claim up to $3,000 in expenses for one dependent or $6,000 in expenses for two or more dependents.
Assume the following:
- You have one eligible dependent.
- You spent $3,600 on childcare expenses during the tax year.
- Based on your income, you can claim 35% of your eligible expenses.
In this scenario, you can’t claim the full $3,600 in expenses, so you’d multiply $3,000 by 35% to determine the amount of your credit.
Tax Deductions
Medical Expense Deduction
The medical expense deduction allows you to deduct unreimbursed medical expenses on your federal tax return. However, you can’t use this deduction unless you itemize, which involves deducting specific expenses rather than taking the standard deduction. Itemizing doesn’t always save you the most money, so consult with a tax professional before you take this deduction.
If you decide that itemizing is right for your situation, you can only deduct medical expenses that exceed 7.5% of your adjusted gross income. Here’s an example:
Assume you have an AGI of $60,000 and $7,000 in unreimbursed medical expenses. If you multiply $60,000 by 0.075, you get $4,500. You can only deduct expenses exceeding the 7.5% threshold, so your deduction would be $2,500, not the full $7,000.
An unreimbursed medical expense is any expense that hasn’t been reimbursed by your health insurance company or another entity. Note that you can’t claim expenses that were paid from a flexible spending account or a health savings account, as both types of accounts already have tax advantages.
Mortgage Interest Deduction
If you have a home loan, you may be able to deduct the interest on your federal tax return. To qualify for this deduction, you must file Form 1040 or Form 1040-SR, itemize your deductions on Schedule A and have an ownership interest in the mortgaged property.
The amount of money you can deduct depends on the amount of your mortgage and when you took it out. Calculating the deduction can be a bit tricky, so don’t be afraid to consult a qualified tax professional.
Student Loan Interest Deduction
If you have student loans, the IRS allows you to deduct $2,500 or the amount of interest you paid during the year, whichever is less. For example, if you paid $2,346 in interest during the year, you can deduct $2,346 from your AGI. You can’t deduct the full $2,500.
Additionally, you can’t claim the student loan interest deduction if you earn more than $75,000 as a single filer or $155,000 if married filing jointly.
Making Sense of Tax Credits vs. Deductions
Credit and deduction amounts aren’t set in stone. The IRS may decide to change the eligibility criteria for some of these credits and deductions. It’s wise to consult a tax professional if you need help determining the best way to file your tax return.
Note that the credits and deductions above apply to your federal tax return only. Your state may offer additional savings opportunities, or it may have different eligibility criteria. Ask your tax professional if you qualify for any state-level credits or deductions.
Visit Credit.com for more information that may help you during tax season.
