Tax Credit vs. Tax Deduction

Are you trying to figure out how to maximize your tax refund? Understanding tax credits and tax deductions can help you streamline your tax return and reduce your overall tax liability.

Tax credits reduce your tax bill dollar for dollar by the amount of the credit. Tax deductions reduce your taxable income, which can reduce your overall tax liability.

While tax deductions have less of an impact than tax credits, you may be able to claim both on your tax return.

What is a tax credit?

When you are eligible for a tax credit, you subtract the amount of the credit from the general federal income tax you must pay. This dollar-for-dollar reduction has the power to dramatically reduce your overall tax liability.

Non-refundable tax credits can bring your total tax liability to $0. Refundable tax credits (such as the Child Tax Credit or the Earned Income Tax Credit) entitle taxpayers to a refund, even if they have $0 in tax liability.

For example, a married couple earning $120,000 with two children under the age of 17 can claim a $2,000 tax credit for each child. The Child Tax Credit will reduce your tax liability by $4,000.

Some popular tax credits include:

• He saver’s credit You can claim if you meet income requirements and contribute to an eligible retirement account.
• He American Opportunity Tax Credit allows you to claim a tax credit for higher education expenses when you or a dependent attend school. You can only claim the AOTC for four years.
• He Lifetime Learning Credit allows you to claim a credit for higher education expenses beyond the first four years.
• If you pay for day care or other forms of dependent care, see the Child and Dependent Care Credit.

What is a tax deduction?

Tax deductions reduce your taxable income, which reduces your tax liability. This is the amount of the deduction multiplied by your marginal tax rate.

For example, a married couple (filing jointly) earning a combined $120,000 has a marginal tax rate of 22%. If this couple contributes $10,000 to a 401(k), they will have a $10,000 tax deduction. Given your marginal tax rate, they will reduce your tax liability by 22% of $10,000 or $2,200.

Some of the most important tax deductions include:

• Business expenses associated with your side hustle.
• Pre-tax contributions to retirement accounts, such as 401(k) or IRA contributions.
• Itemized deductions, such as property taxes, charitable contributions, and medical expenses.

Which is better: a tax credit or a tax deduction?

Tax credits reduce your tax liability per dollar, based on the amount of credit you receive, while tax deductions only reduce your taxable income.

Consider a single person who makes $50,000 and spends $2,500 on higher education expenses and contributes $2,500 to their 401(k).

This is how it breaks down:

• This taxpayer is eligible for the American Opportunity Tax Credit, which reduces their tax bill by $2,500.
• She is also eligible for a $2,500 tax deduction due to her 401(k) contributions.
• Given your marginal tax rate of 22%, the $2,500 contribution to the 401(k) only reduces your tax bill by $550.

Tax credits are more powerful than tax deductions, but you rarely have to choose between the two. Take advantage of as many credits and deductions as you qualify for to keep your tax liability low.

Do I need to know whether to claim a tax credit or a deduction?

Unless you file your taxes by hand, you don’t need to know what credits or deductions to claim.

The best tax software (including free tax software) can streamline your tax return, so you get the most refund based on your situation.

Your eligibility for credits and deductions often depends on multiple factors, including your income and other credits or deductions you claim.

The software can optimize these factors on your behalf.