Tax Deductions vs Tax Credits

This blog post was written by Student Advisory Council member, Eddie Richardson.

Many people know that both tax deductions and tax credits can lower the amount of tax that they owe, but the distinction between the two is often confused. Even if the end result can be the same for both, it is important to understand how each operates in order to stay organized as tax season approaches.

What are tax deductions?

A deduction reduces the amount of income you pay taxes on. You subtract deductions from your income before calculating how much you owe in taxes. One example of a tax deduction is the standard deduction, which is available to all taxpayers. The standard deduction amount may change each year, and it also depends on your filing status.

To calculate how much a deduction could reduce your taxes, you multiply the amount of the deduction by your marginal tax rate. For example, if a deduction is worth $5,000 and you are in the 10% tax bracket (the lowest), the deduction would reduce your taxes by $500.

At the federal level, most deductions are available only if the taxpayer itemizes expenses on a separate tax form rather than taking the standard deduction. Businesses large and small must itemize their deductions in order to deduct the expenses of doing business from the gross proceeds of the business, thus arriving at a taxable income. Individuals, however, have a choice between taking the standard deduction or itemizing deductions.

• The standard deduction for the 2021 tax year is $12,550 for single taxpayers or married taxpayers filing separately. It is $25,100 for couples filing jointly and surviving spouses and $18,800 for a single head of household.
• For the 2022 tax year, the standard deduction is $12,950 for single taxpayers or married taxpayers filing separately. It is $25,900 for couples filing jointly and surviving spouses and $19,400 for a single head of household. Click here for more on the annual inflation adjustments made by the IRS for 2022.

For any taxpayer who does not have itemized deductions that exceed these amounts, the standard deduction is often the right choice.

What are tax credits?

A tax credit is a dollar-for-dollar reduction in the amount of tax you owe. For example, if you qualify for a $1,000 tax credit of some kind and owe $5,000 in taxes, that credit will reduce your tax burden to $4,000.

Credits are generally designed to encourage or reward certain types of behavior that are considered beneficial to the economy, the environment or to further any other purpose the government deems important. One of the most substantial credits for taxpayers is the Earned Income Tax Credit (EITC). Established in 1975—in part to offset the burden of Social Security taxes and to provide an incentive to work—the EITC is determined by income and is phased in according to filing status: single, married filing jointly or either of those with children.

What is the difference in how each works?

The big difference between tax deductions vs. tax credits is that deductions chip away at the income you’ll pay taxes on, which then reduces your taxes, while credits directly reduce the amount of taxes you owe.

What are the benefits of tax deductions?

Tax deductions are designed to offset the amount of income you’ll pay taxes on by writing off expenses like tuition and healthcare, contributions to retirement and any self-employed or capital gains losses you faced. Claiming a deduction ensures you don’t pay taxes on certain income you’ve already spent, invested or lost.

What are the benefits of tax credits?

In addition to reducing the amount you pay in taxes or increasing a refund, some tax credits can be claimed even if you have no tax liability. That means that if you don’t owe any taxes but qualify for $1,000 in refundable tax credits, you can get these credits as a $1,000 refund.

What are some common tax deductions you might be eligible for?

• The standard deduction — Instead of itemizing deductions, many taxpayers claim a standard deduction because it can be simpler than itemizing all of their deductions individually. How much you can deduct using the standard deduction mostly depends on your filing status and age.
• Student loan interest — If you pay interest on a qualified student loan, you may be eligible to deduct up to $2,500. You don’t have to itemize deductions to take the student loan interest deduction.
• Medical and dental expenses — Qualified medical and dental costs are tax deductible as long as they exceed a set percentage of your adjusted gross income.
• State and local income tax — You may be allowed to deduct state, local and foreign income taxes.
• Property taxes — If you pay taxes for property like land, cars or boats, that tax may be deductible.
• Mortgage interest — If you pay mortgage insurance premiums, interest on a mortgage or points, they may be deductible.
• Retirement contributions — Contributions to a traditional 401(k) or a traditional IRA are often eligible for deductions.
• Contributions to a health savings account — If you have a high-deductible health plan and contribute to an HSA in conjunction with that plan, your HSA contributions are generally tax deductible.

What are some common tax credits you might be eligible for?

• Earned income tax credit (EITC) — If you are working and earn a low to moderate income, you could be eligible to claim the EITC, which is a refundable tax credit.
• Child Tax Credit — This program can reduce the Federal tax you owe by $1000 for each qualifying child under the age of 17
• Lifetime learning credit — Depending on your modified gross income, you may be able to get a credit for up to $2,000 for qualified tuition and education-related expenses for yourself, a spouse or dependent.
• Saver’s tax credit — This credit helps individuals who meet adjusted gross income requirements save for retirement.
• Residential energy-efficient property credit — If you’re a homeowner and have made investments in order to make your home more energy-efficient, you may be able to receive a credit for those expenses.

Taxes have many complexities. We encourage you to visit IRS.gov or your tax professional for additional details regarding your specific situation.