Tax Deductions vs Tax Credits: Key Differences & Similarities

Many people mix up the difference between a tax credit and a tax deduction. They’re both designed to reduce the amount of taxes you owe to the IRS, both are available to a variety of individuals, including employees, self-employed individuals, and business owners, and both come from expenses you incur or activities you participate in that are considered eligible by the government. However, despite their similarities, there are some key differences between the two.

FEATURED COURSE

Lorilyn Wilson teaches Taxes & Accounting Foundations For Business Owners

Lorilyn Wilson, CPA, teaches you how to properly set-up your business (from choosing the right business entity to creating a financial forecast) and the must-dos ALL business owners need to understand when it comes to preparing your taxes (including expenses, write-offs, and how-to lower your risk of being audited).

View Course

What is a tax deduction?

A tax deduction is a decrease in your taxable income, which reduces the amount of income that is subject to tax. Tax deductions are typically claimed for expenses or activities that are considered eligible by the IRS, such as charitable donations, mortgage interest, and medical expenses.

When you claim a tax deduction, you subtract the amount of the deduction from your taxable income for the year. For example, if you have a taxable income of $80,000 and claim a $3,000 deduction, your taxable income would now be $77,000.

What is a tax credit?

With a tax deduction, we’re reducing our taxable income; with a tax credit, we’re reducing our bottom line tax bill.

A tax credit is a dollar-for-dollar reduction of your tax liability (how much you owe in taxes, or in other words, your bottom line tax bill). Tax credits are typically offered for expenses or activities that the government considers to be beneficial, such as supporting a child, pursuing higher education, or making energy-efficient home improvements.

When you claim a tax credit, the amount of the credit is subtracted directly from your tax liability, reducing the amount of tax you owe. For example, if you have a tax liability of $3,000 and claim a $500 tax credit, your tax liability would now be $2,500.

Main Differences

A tax deduction reduces the amount of your income that is taxed, while a tax credit directly reduces the amount of taxes you owe.

A tax deduction reduces the amount of your income that is subject to taxes. For example, if you make $50,000 and you have a $2,000 tax deduction, you would only have to pay taxes on $48,000 of your income. On the other hand, a tax credit is a direct reduction of the amount of taxes you owe. For example, if you owe $1,000 in taxes and you have a $200 tax credit, your tax bill would go down to $800.

Here are the main differences between tax deductions and tax credits

Direct reduction vs. reduction of taxable income: Tax credits reduce the amount of tax you owe dollar-for-dollar, while tax deductions lower your taxable income, which reduces the amount of income that is subject to tax.

Value: Tax credits are generally more valuable than tax deductions because they directly reduce the amount of tax you owe, while deductions only lower your taxable income.

Eligibility: Not everyone is eligible for every tax credit or deduction, and some may have restrictions or limits based on factors such as income, age, or type of expense.

Application: To claim a tax credit, you need to complete the appropriate tax form and include the credit you’re claiming. To claim a tax deduction, you need to reduce your taxable income by the amount of the deduction.

Record-keeping: To claim a tax credit or deduction, you need to keep records of any expenses or documentation related to the credit or deduction, such as receipts, invoices, or forms from the provider of the credit.

What’s better: A tax deduction or a tax credit?

In general, tax credits tend to be more valuable than tax deductions because they directly reduce the amount of tax you owe, while deductions only lower your taxable income.

However, it really depends on your individual situation. The specific value of a tax credit or deduction will depend on your individual tax bracket and the amount of the credit or deduction. Also, not everyone is eligible for every tax credit or deduction, and some may have restrictions or limits.

Example: John and Jill both make $80,000 in income. John gets a tax deduction of $10,000 and Jill gets a tax credit of $10,000. As a result, John’s income is now $70,000 after the deduction and Jill’s income remains the same because there was no deduction. At a 25% tax rate, John, with $70,000 in income, owes $17,500 in income taxes to the IRS. Jill, on the other hand, gets taxed at the full $80,000 in income, which amounts to $20,000 in taxes owed. However, because she has a $10,000 tax credit, that amount gets deducted from the final tax bill. With the credit applied, her taxes owed is now just $10,000. She pays $7,500 less than John.

Also read: The Most Common Tax Deductions & Tax Credits