Personal Finance

Tax Deductions vs. Tax Credits: What's the Difference, and Why Does It Matter?

1040 form with pen and calculator

When doing your taxes, the goal is to maximize the credits and deductions you're eligible for. While you probably know both credits and deductions lower your tax bill, do you know the difference between them? The difference is important, since tax credits are worth more than deductions with the same value.

Read on to find out the key differences between tax credits and tax deductions -- and to find out about a special feature of some credits that could result in the government sending you back more money than you paid in.

1040 form with pen and calculator

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What's the difference between tax credits and tax deductions?

While both tax credits and tax deductions lower your taxes, they work differently.

  • Tax credits are a dollar-for-dollar reduction on your tax bill. If you owe $5,000 in taxes and get a $500 credit, you'll only owe $4,500. A credit is worth the same for everyone, regardless of tax rate, as long as the tax filer is eligible to claim the credit.
  • Tax deductions reduce your taxable income. If you get a $500 deduction and your taxable income was $40,000, the credit brings your taxable income to $39,000. The value of your deduction is determined by your effective tax rate and equal to taxes you'd have paid on income that went untaxed because of the deduction. In 2018, income between $38,701 and $82,500 is taxed at 22% for a single person. A $500 deduction means you're not taxed on $500 worth of income that would've been taxed at 22%, so the deduction is worth $110 ($500 x 22%). It's worth less than a $500 credit would've been worth.

The higher your income, the more a tax deduction is worth. A single person with an income above $550,000 would be taxed at 37% in 2018, so if his income came down to $549,500, the deduction would save him $500 x 37%, or $185. However, many popular tax deductions, such as the deduction for student loan interest , aren't available to higher earners because of income limits on the deduction.

While being in a higher tax bracket means your deduction is worth more, no deduction is ever worth more than a credit of equivalent value since taxes owed are reduced by 100% of the credit, but a deduction's value is determined by effective tax rate, and no one is taxed at 100%.

Some, but not all, credits are refundable

So, now you know a $500 credit is always worth $500 and will reduce your tax bill dollar for dollar. But, what happens if a credit you're eligible for is worth more than the taxes you owe? For example, what if you're eligible for $3,000 worth of tax credits but your tax bill is only $1,500?

In this particular situation, one of three things might happen:

  • You might get sent a check from the IRS for the amount of the credit owed to you after your tax liability was reduced to $0. This happens if a credit is refundable. If you had $3,000 in refundable credits but owed $1,500, your credits would reduce your bill to $0, and you'd get $1,500 from the IRS. The Earned Income Tax Credit is an example of a refundable tax credit claimed by many families.
  • You might lose some of the credit . This happens if the credit is non-refundable and can only reduce your taxes to $0, or if is only partially refundable. Some credits, such as the Foreign Tax Credit , aren't refundable at all, so you lose the entire remaining balance after your tax bill has been reduced to $0. Others, like the American Opportunity Tax Credit , are partially refundable, so you'd get some money sent to you, but maybe not the full balance remaining after taxes were reduced to nothing.
  • You might be able to keep the unused balance from the credit and reduce taxes the following year. This can happen, for example, if you claim renewable energy credits for installing a solar power system. You might get a $6,000 renewable energy credit, and if you owe only $5,000, you'd be able to use your credit to reduce your taxes to $0 and carry over your remaining $1,000 to reduce your taxes next year.

When you're doing your tax planning, it's important to determine if credits you're eligible for are refundable or not so you'll know whether to expect money back from the IRS.

Claiming your deductions and credits

While credits are more valuable than deductions, it's still important that you claim both so you can reduce your tax bill as much as possible and keep more money in your pocket. Online tax software can help you identify credits and deductions you can claim, and tax professionals can also provide the help you need if you have a more complex tax situation.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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