Why Tax Credits Are Worth More Than Deductions

Do you know the difference between these two tax-saving tools?

Saving as much as possible on your tax bill is a smart financial move. In order to do that, you probably already know you want to claim as many deductions and credits as you can. The best tax software can help you do just that.

But do you know the difference between a deduction and a credit?

The two are not the same, and credits can provide you with much more tax savings than deductions can. It's important to understand how each works so you can make plans for how much you'll owe the IRS after you've taken advantage of all the opportunities you have to save.

What's the difference between a tax deduction and a tax credit?

The big difference between a tax credit and a tax deduction is that deductions reduce your taxable income, while credits reduce the taxes due on a dollar-for-dollar basis.

This may seem confusing, so let's look at how a $2,000 credit would impact your taxes versus a $2,000 deduction.

• A $2,000 deduction brings your taxable income down. If you had $45,000 in taxable income, then the effect of a $2,000 deduction is that you are only taxed on $43,000 of the money you made instead of on the full $45,000. The tax savings results from the fact you don't pay tax on the $2,000 you were able to deduct. So if you were in the 22% tax bracket, you would reduce your tax bill by up to 22% of the $2,000 that's now going untaxed. That would provide savings of $440.
• A $2,000 credit reduces your tax bill after the taxes due have been calculated. So, if you owed $5,000 in taxes and got a $2,000 credit, then your total tax bill would come down to $3,000 since you can subtract the entire amount of your $2,000 credit from your IRS bill. The savings would be $2,000 from the credit -- which is obviously much higher than $440.

Tax credits can be fully or partly refundable

The other major benefit of tax credits is that they are sometimes fully or partly refundable. This means if the amount of your credit exceeds the taxes you are required to pay, you'd actually end up getting back more than you paid in.

For example, consider the expanded Child Tax Credit that was available in 2021 under the American Rescue Plan Act. It provided a fully refundable tax credit of up to $3,600 per child under 6 years old and $3,000 per older child. If you were entitled to the $3,600 credit but only owed a total of $3,000 in federal taxes, the credit would reduce your bill to $0 and you'd get an extra $600 refund on top of paying no taxes.

Now, obviously you can't choose whether you'll be able to claim a credit or a deduction. Your ability to claim either depends on tax rules and your expenditures. But as you consider what your tax bill will be after the savings available to you, it's helpful to understand these rules.