Tax Deductions vs Tax Credits: What’s the Difference?
Tax credits and tax deductions aren't the same and can have a different impact on your taxes. Knowing the difference between deductions & credits can be helpful when analyzing certain decisions that have tax implications.
Tax Deductions
A tax deduction is a provision that allows you to reduce your taxable income, or the amount of income you pay tax on. Keep in mind that it's taxable income that gets fed through the marginal tax brackets to determine the amount of tax that you owe.
Tax Deduction Example
A single tax filer has the follow information:
$200,000 income
$14,600 standard deduction
$23,000 401(k) deduction (pre-tax 401k)
This individual would have a taxable income of $164,000.
$200,000 (income) - $14,600 (standard deduction) - $23,000 (pre-tax 401k deduction) = $164,000 (taxable income)
This taxable income would then be fed through the marginal tax brackets to determine the total tax due. They would pay 10% tax on the first $11,600, 12% tax on the next $35,550, 24% tax on the next $53,375, and so on until the entire $164k has been allocated.
Notable Tax Deductions
The most notable tax deductions are:
Standard deduction
Mortgage interest deduction
Capital loss deduction
Retirement contributions (401ks, IRAs, etc.)
Medical expenses deduction
Deduction for state and local taxes (SALT)
Charitable donations
Student loan interest
Health savings account (HSA) & flex spending account (FSA) contributions
Key Points on Deductions
Tax deductions can either be above the line or below the line with the "line" being adjusted gross income (AGI). Above the line deductions are often beneficial in reducing AGI and qualifying taxpayers for a wider array of tax benefits that have hard AGI limits.
Also, itemized deductions are not available to you if you choose the "standard deduction". On the contrary, if you choose to "itemize" your deductions you have a wider array of deductions to apply to your tax return.
However, it only makes sense if you can accumulate more itemized deductions than the standard deduction. Sometimes it can make sense to "bunch" two separate years worth of deductions into one (think prepaying the upcoming year).
This is where a professional can help you decide itemize or choose the standard deduction.
There may also be “phase outs” where a tax deduction is gradually reduced as income approaches the upper limit to qualify for that deduction.
Tax Credits
Tax credits are provisions that reduce your tax liability, or tax you owe, dollar for dollar.
Tax Credit Example
A tax filer has the following:
$7,500 tax bill
$3,000 in tax credits
The individual would have a new tax liability of $4,500.
$7,500 (tax bill) - $3,000 (tax credits) = $4,500 (new tax bill)
Notable Tax Credits
The most notable tax credits are:
Child tax credit
Child & dependent care tax credit
American Opportunity & Lifetime Learning credit
Earned income tax credit
Retirement saver's credit
Alternative minimum tax (AMT) carry forward credit
Electric Vehicle (EV) and energy tax credits
Types of Tax Credits
Tax credits can either be refundable, partially refundable, or non-refundable and it’s important to know the difference.
Refundable
Refundable credits will return money to you if the credit(s) create a negative tax bill (total credits exceed what you owe).
For example, if your tax bill is $1,500 and you have a $2,000 refundable credit then you’d receive a $500 refund.
Non-Refundable
Non-refundable credits can only offset your tax bill to $0 at the most.
Using the same example, your $2,000 credit would only eliminate your $1,500 tax bill. You would not receive a refund for the difference.
Partially Refundable
Partially refundable credits will only refund up to a certain amount of the overall credit.
Let’s look at the child tax credit which is partially refundable. Currently, the child tax credit is a $2,000 tax credit with up to $1,700 being partially refundable. Here’s how it would affect different scenarios:
As you can see, you will be refunded the lesser of $1,700 or the balance of the credit after your tax bill has been eliminated.
Key Points on Credits
There may also be “phase outs” where a tax credit is gradually reduced as income approaches the upper limit to qualify for that credit.
Compare and Evaluate
Finally, if you ever want to compare a deduction to a credit there is a way to compare apples to apples. You may need to do this if you have to choose one or the other.
You can do this by doing either of the following:
Dividing the tax credit by your marginal tax rate to get the comparable deduction.
$3,000 tax credit / 32% (marginal tax bracket) = $9,375 deduction
Multiply the deduction by your marginal tax rate to get the comparable credit.
$9,375 deduction X 32% (marginal tax bracket) = $3,000 credit
Conclusion
Tax deductions reduce taxable income, can be above or below the AGI line, can be bunched (if itemized), can be itemized or the standard deduction, and can be subject to phaseouts.
Tax credits reduce your tax bill dollar for dollar, can be different types (refundable, partially refundable, or non-refundable), and can be subject to phaseouts.
Tax deductions and credits may have different restrictions, requirements, and phase outs attached to them which may limit their use. But if you qualify, they can offer huge tax savings when used properly. Because of the nuance of the tax code, it often makes sense to work with a professional to make sure you’re getting the most out of what’s available to you.
