Tax Credits vs. Tax Deductions: What’s the Difference & Why It Matters

When tax season rolls around, terms like “tax credits” and “tax deductions” often get thrown around, but many taxpayers aren’t fully aware of how they differ and the financial impact each can have. Understanding these differences can help you maximize your tax savings and keep more of your hard-earned money.

Why Are There Two Types?

The tax code includes both deductions and credits to serve different purposes. Deductions primarily exist to account for necessary expenses related to earning income, ensuring that taxpayers are taxed on their actual net earnings rather than their gross income. On the other hand, tax credits are often designed as incentives to encourage certain behaviors, such as saving for retirement, investing in education, or adopting energy-efficient practices. By offering credits, the government can promote economic and social policies that benefit individuals and the broader economy.

Tax Deductions: Reducing Your Taxable Income

A tax deduction lowers the amount of income subject to taxation, reducing your overall tax liability. Deductions work by decreasing your taxable income, which in turn lowers the amount of tax you owe based on your tax bracket.

Example: If you have $60,000 in taxable income and claim a $5,000 deduction, your taxable income is reduced to $55,000. If you’re in the 22% tax bracket, that deduction saves you $1,100 in taxes ($5,000 x 22%).

Common tax deductions include:

Mortgage Interest Deduction: Homeowners can deduct interest paid on mortgages up to a certain limit.
Student Loan Interest Deduction: Borrowers can deduct up to $2,500 in student loan interest paid.
State and Local Tax (SALT) Deduction: Taxpayers can deduct up to $10,000 in state and local property, income, or sales taxes.

While deductions lower taxable income, the actual tax savings depend on your income level and tax bracket.

Tax Credits: Directly Reducing Your Tax Bill

Unlike deductions, tax credits provide a dollar-for-dollar reduction of your tax liability. This means that a $1,000 tax credit reduces your tax bill by the full $1,000, regardless of your income level.

Example: If you owe $5,000 in taxes and qualify for a $1,500 tax credit, your tax bill drops to $3,500.

Tax credits come in two forms:

Nonrefundable Tax Credits: These can reduce your tax liability to zero but won’t result in a refund if the credit exceeds your tax owed. Examples include the Child and Dependent Care Credit and the Lifetime Learning Credit.
Refundable Tax Credits: These not only reduce your tax bill but can also generate a refund if the credit amount exceeds your total tax owed. Examples include the Earned Income Tax Credit (EITC) and the Additional Child Tax Credit.

Common Tax Credits

Child Tax Credit (CTC): Provides up to $2,000 per child, with up to $1,700 refundable in 2024.
Earned Income Tax Credit (EITC): A credit for low- to moderate-income workers that can result in a significant refund.
American Opportunity Tax Credit (AOTC): Up to $2,500 per eligible student for the first four years of college.
Residential Clean Energy Credit: Covers 30% of the cost of qualified energy-efficient home improvements.

Which Is More Valuable?

Generally, tax credits offer greater savings because they reduce your tax bill directly, whereas deductions only lower taxable income. However, deductions can still be highly beneficial, particularly for higher-income earners in higher tax brackets.

Final Thoughts

Maximizing both tax deductions and credits requires careful tax planning. While deductions help lower your taxable income, credits provide direct savings on your tax bill. Understanding how to use both effectively can make a significant difference in your overall tax savings.

If you’re unsure how to optimize your tax strategy, give us a call to ensure you take advantage of all available deductions and credits.