Tax deductions vs tax credits

Two ways to lower your annual tax bill

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Key Takeaways

  • Deductions are subtracted from your total income to find your taxable income, which is then multiplied by the tax brackets to find how much tax you owe

  • Credits reduce your tax liability (how much tax you owe) and directly lower your annual bill, so they’re usually more valuable

  • Most deductions apply to specific personal expenses you incurred during the year, like mortgage interest

  • Eligibility for most credits is based on your income, with low income tax filers and those with children benefiting most

Deductions and credits both help to decrease how much income tax you pay, but they each do that differently. To understand the difference, you need to know that your tax liability — the amount of federal income tax you owe in a given year — is determined by multiplying the federal tax brackets by your taxable income. Taxable income is not the same as your total income for the year (known as gross income).

Deductions reduce your taxable income. So a deduction will ultimately decrease the amount you have to pay in tax, but it doesn’t directly lower your tax bill. For example, if you made $60,000 during the year and qualify for $15,000 in deductions, only $45,000 of your income is subject to tax.

Tax credits are applied after your exact liability has been calculated, and they directly reduce how much tax you owe. Credits are usually more valuable than deductions because they directly lower your bill. For example, if you complete your tax return and owe $500, but then you qualify for $1,000 in tax credits, you won’t owe anything and could even get a refund of $500, depending on the type of credit.

The majority of federal tax credits are available to low-income taxpayers and taxpayers with children. Eligibility is often based on your income, with a phase-out that limits how much you can get if you have a higher income. Tax deductions are based on a certain type of personal expense that you may have incurred, like money a teacher pays out of pocket for classroom materials.

Learn more about your income taxes with our complete guide to filing taxes.

How tax deductions work

Deductions reduce your taxable income. Taxable income is your total income minus the value of your deductions, and the federal government finds your annual tax bill by multiplying your taxable income by a percentage, as determined by the federal tax brackets. Claiming a deduction ultimately decreases the amount you have to pay in tax, but it doesn’t directly lower your tax bill.

Deductions are based on certain personal expenses you incurred during the year. In almost all cases, you need to attach additional forms to claim a deduction.

The two types of deductions

There are two main kinds of deductions: above-the-line and below-the-line deductions. An above-the-line deduction is available to everyone who meets its individual qualifications. If you paid interest on a student loan, you can claim the student loan interest deduction. Above-the-line deductions are officially called adjustments to income and you claim them by filling out Schedule 1 and attaching it to your tax return.

Then there’s the standard deduction, which is available to all taxpayers and based on your filing status instead of your financial situation. If you have certain types of expenses, you may qualify to itemize your deductions instead of the standard deduction. Itemized deductions are called below-the-line deductions. Most people don’t qualify to itemize (they save more by taking the standard deduction), but you can claim them by attaching Schedule A to your federal tax return. There is one other below-the-line deduction, the QBI deduction, which is available to everyone with qualifying business income.

Learn more about the kinds of deductions.

How tax credits work

Tax credits apply to your tax liability, which is the amount you actually owe for the year. Credits directly lower your liability. If you owe $2,500 of income tax at the end of the year and you are eligible for $2,500 of tax credits, then your liability is now zero.

Eligibility for credits is usually determined by your income, and most credits benefit either low-income individuals or people with children. You may still have to attach additional forms to your tax return to claim credits, but a handful are also available directly on Form 1040 — the main tax form.

Some tax credits are also available to take in advance; you take them at the beginning of the year for expenses you anticipate, and then on your your tax return you just confirm how much you actually spent. A common example is the advance premium tax credit, which you can claim at the beginning of the year to pay your monthly health insurance premiums.

The two types of credits

There are two types of tax credits: nonrefundable and refundable. With a nonrefundable credit, it will only decrease the amount of tax you owe to zero, instead of giving you a refund. For example, if you owe $1,000 in taxes but qualify for $1,500 in nonrefundable credits, your tax bill for the year is $0 and you don’t get any money back.

Refundable credits can bring your tax liability below zero and result in a refund. If you owe $1,000 in taxes but have $1,500 in refundable credits, then you will get a $500 refund from the IRS.

Learn more about tax credits in our guide to refundable and nonrefundable credits.