Tax Credits vs. tax deductions: what’s the difference?
Delve into tax credits vs. tax deductions, examine their differences, pros, and cons, and take a look at tax exemptions with this article.
Summary
Tax credits can reduce the amount of tax you owe the government.
Tax deductions can reduce your taxable income for the year.
Apply credits before you apply the tax rate and apply deductions after calculating the tax due.
Tax credits might result in a refund; deductions do not generate refunds.
What are tax credits?
To begin to understand tax credits vs. deductions, we need first to know what those two terms mean, starting with tax credits. These reduce the amount of taxes you owe, and in most cases, that reduction is dollar for dollar.
If you meet the relevant income, age, and tax filing status criteria, you could qualify for a tax credit. Let’s say you owe $3,000 in taxes, and you qualify for a $1,500 tax credit. This will reduce your tax liability by $1,500, so you only need to pay $1,500 in tax.
You could receive a bigger refund if you claim tax credits, but it’s important to remember that some credits cannot be refunded. If your tax credits reduce your tax liability to a negative number, what’s left over will not be used to increase your tax refund’s size. For example, if you owe $4,000 in taxes and you have a $1,500 tax credit, you will not receive the extra $100 in your tax refund check.
However, if you have a refundable tax credit such as the Earned Income Tax Credit, you could receive a bigger refund. You could also receive a partially refundable tax credit, such as the American Opportunity Tax Credit. Now that we know how tax credits work, let’s dive into deductions.
What are tax deductions?
If tax credits lower the amount of tax you owe, what are tax deductions? Unlike credits, tax deductions lower your taxable income for that year. There are two ways to claim deductions.
One way is to itemize your deductions by listing out the individual expenses that you want to write off on your tax return. Examples of deductible expenses in 2023 include charitable donations, tuition and fees, medical and dental expenses, business travel mileage, and job search expenses. Remember that your ability to claim some deductions might be limited by your household income or filing status.
The other way is to claim the standard deduction. The amount that you can deduct depends on your filing status. The biggest standard deduction is available for married couples filing a joint tax return.
Here’s an example of a standard tax deduction in action: Let’s say you’re a single taxpayer who reported a $90,000 earned income in 2022, putting you in the 24% tax bracket. Your tax bill for that year would have been $15,213.50 plus 24% of the excess over $89,075 ($925), which came out to a total of $15,435.50 ($15,213.50 + $222).
The standard deduction for a single filer in the 2022 tax year was $12,950. Let’s say you contributed $6,000 to your IRA, giving you a $6,000 deduction that reduced your gross income from $90,000 to $84,000. The standard deduction reduces your taxable income further to $71,050, leaving you with a tax bill of $11,248 ($4807.50 plus 22% of the excess over $41,775).
Tax credit vs tax deductions: what’s the difference?
As you have probably guessed from our look at tax credits vs. tax deductions so far, there are multiple differences between the two.
Learn more about their differences in the table below.
| Tax credits | Tax deductions | |
|---|---|---|
| Benefits | Reduces tax liability by offsetting taxes owed | Reduces the amount of income subject to taxes |
| Point of adjustment | Before the application of the tax rate | After you have ascertained the tax due |
| Reductions/deductions | Every $1 of credit usually reduces taxes owed by $1 | Deductions can be itemized or standard |
| Potential increases/decreases | Refundable credits can increase tax refund size | Deductions become more valuable the more income you earn |
| Availability | Some credits are available to certain income levels only | Some deductions are limited and are based on income and other factors |
Tax credit vs tax deductions: what are the pros and cons?
Our exploration of tax credits vs. tax deductions is incomplete without mentioning the pros and cons of each. Find out what their pros and cons are in the table below.
Tax credits pros:
Reduce the amount of tax you owe
This might result in a refund
Usually designed for low- to moderate-income families
Tax credits cons:
Claiming credits can delay your refund
Strict eligibility criteria
Tax deductions pros:
Reduce your taxable income
Helpful for self-employed people with business expenses
You can claim the standard deduction easily
Tax deductions cons:
Itemized deductions involve lots of paperwork
Deductions do not generate refunds
Deciding between standard and itemized deductions can be difficult
What are tax exemptions?
The term refers to income or transactions that are free from tax at the local, state, or federal level. Any reporting of them on your return is for informational purposes only.
One example of income with tax exemptions is the interest earned on municipal bonds. Any interest you make on these bonds issued in your state of residence is exempt from state and federal taxes.
Need more information?
You can benefit from tax credits and tax deductions, although both also have cons. Ensure you understand the differences between tax credits and tax deductions, know what the implications are for your finances, and take advantage of them appropriately.
Let Unbiased match you with an SEC-regulated financial advisor whom you can turn to for expert financial advice on tax, saving, and taking control of your money.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.