Credits vs. Deductions: What’s the Difference?

Tax deductions and tax credits can both help you, but that doesn’t mean they’re the same thing. Knowing how they work can help you understand your tax situation.

Tax credits are subtracted from your final tax liability, dollar for dollar, after it is calculated. A tax credit valued at $1,000, for example, lowers your tax bill by $1,000. How you qualify depends on the credit but may include your age, income or tax-filing status (single, married filing separately or married filing jointly).

Common tax credits

You may be eligible for these:

• Child and Dependent Care Credit, which is designed to help offset the cost of childcare or taking care of an elderly parent.
• Adoption Credit, for adoption expenses.
• Child Tax Credit, for parents of dependent children.
• Premium Tax Credit, for people who purchased health insurance through the federal marketplace.
• Saver’s Credit, for people who contributed to a tax-advantaged retirement account.
• Lifetime Learning Credit, for higher education and job-training expenses.

Tax credits come in two main flavors: refundable and nonrefundable. If a credit is nonrefundable, it means that you won’t get a tax refund if your credit is worth more than your tax bill. A refundable tax credit is the opposite: If you owe $500 in taxes and qualify for a $1,000 refundable tax credit, you’ll get a check for the remaining $500 from Uncle Sam. If the credit is partially refundable, you’ll receive some percentage of the overage as a refund.

What about deductions?

Tax deductions reduce how much of your income is subject to taxes. Deductions lower your taxable income by the percentage of your highest federal income tax bracket. If you fall into the 22% tax bracket, a $1,000 deduction saves you $220.

There are several ways to claim deductions:

• The standard deduction can be claimed automatically. How much you can deduct depends on your filing status. The largest standard deduction is set aside for married couples filing a joint tax return.
• Itemizing deductions means listing individual expenses you want to write off on your return. It generally makes the most sense to use if your total deductible expenses are higher than the standard deduction.
• Above-the-line deductions, such as the student loan interest deduction, can be claimed as separate deductions even if you’re not itemizing deductions.

You can’t claim a credit and a deduction for the same qualified expense. If you paid out of pocket to go back to school for a graduate degree, for instance, you couldn’t claim both the tuition and fees deduction and a Lifetime Learning Credit.

Tax deductions and tax credits are ways to decrease your tax burden. Tax credits are generally considered to be better than tax deductions because they directly reduce the amount of tax you owe. If you’re eligible for both a tax credit and a deduction for the same expenses, crunching some numbers can help you determine which will offer the biggest tax break. As with all tax issues, consider working with a tax professional to make sure you claim everything you’re entitled to.