When doing your taxes, the goal is to maximize the tax credits and deductions for which you’re eligible. But tax credits are worth more than deductions with the same value, so knowing the differences between the two will help you save money on taxes.

Key Difference

Both credits and deductions lower your tax bill but in different ways and with different outcomes. Tax credits lower your tax liability while tax deductions reduce your taxable income. For instance, someone who’s in the 25% tax bracket with a $100 tax credit will save $100 dollars in taxes, but if that same person has a $100 deduction, they will only save $25 in taxes (25% of $100).

Tax Credits

Tax credits are a dollar-for-dollar reduction on your tax bill, regardless of tax rate, which explains the $100 savings with a $100 tax credit in the previous example. Taking advantage of eligible tax credits after applying all deductions will help to slash your taxes due. Some of the more popular tax credits include:

  • Earned Income Tax Credit (EIC or EITC)
  • Child Tax Credit
  • Child and Dependent Care Credit
  • American Opportunity Tax Credit
  • Lifetime Learning Credit
  • Adoption Credit
  • Saver’s Credit
  • Residential Energy Tax Credit

Refundable Tax Credits vs. Non-Refundable Tax Credits

Some tax credits are refundable while others are not. When you claim a refundable tax credit that exceeds your total tax liability, the IRS will send you the difference. For example, if your tax liability is $1,000 and then you apply your EITC, which is $2,500, you would use that $2,500 to pay your liability and the remaining $1,500 would be refunded to you. By contrast, a non-refundable tax credit can reduce your federal income tax liability to zero, but any leftover balance from the credit will not be refunded.

Tax Deductions

There are two types of tax income deductions, which reduce the amount of income you’re taxed on: itemized deductions and above-the-line deductions.

Itemized Deductions

Itemized deductions are certain tax-deductible expenses that you incur throughout the year. For some taxpayers, those expenses add up to be greater than the standard deduction amount, in which case, they should itemize their tax returns rather than take the flat-dollar standard deduction. Keep in mind that if you plan to itemize, you should accurately track your spending throughout the year, and keep supporting documentation (receipts, bank statements, check stubs, insurance bills, etc.) in the instance that IRS would ask for proof.

Common itemized deductions include:

  • Medical expenses
  • State and local income taxes
  • Property taxes
  • Mortgage interest
  • Charitable contributions

The standard deduction is a fixed amount that varies in consistency to your filing status. For 2019 returns, the standard deduction is:

  • $12,200 for single filers and married filers filing separately
  • $24,400 for married filers filing jointly
  • $18,350 for heads of household

Above-the-Line Deductions

If you claim the standard deduction, you can use “above-the-line” deductions, which reduce your adjusted gross income (AGI), to lower your tax bill. Some of these deductions are:

  • Health savings account (HSA) contributions
  • Deductible contributions to IRAs
  • The deductible portion of self-employment taxes
  • Contributions to self-employed SEP-IRA, SIMPLE IRA, and other qualified plans
  • Self-employment health insurance premiums
  • Penalties on early savings withdrawals

Above-the-line deductions typically aren’t as valuable as tax credits, but they help to lower your AGI, which can slash your tax liability and qualify you for other tax breaks based on income limits.

Daniel Kittell, CPA - Accountant Indianapolis