Tax Deductions vs. Tax Credits: What’s the Difference?

What is a tax deduction?

A tax deduction reduces your taxable income (the amount of your income that’s taxed by the federal government). If you lower your taxable income, you could reduce the amount of tax you have to pay for a given year.

One popular deduction is the standard deduction. The amount is adjusted each year and is based on your filing status (e.g., single, head of household, etc.).

Here are some other common deductions you may already be familiar with:

• Health Savings Account (HSA) contribution
• Traditional IRA contribution
• Charitable contribution
• Mortgage interest
• State and local tax

Keep in mind that many deductions come with certain restrictions and eligibility rules. So just because a tax deduction exists doesn’t mean you can automatically claim it on your tax return. Always confirm the qualification rules with the IRS or a professional tax preparer.

A closer look at how a tax deduction works

A tax deduction can help lower your taxable income. But by how much? It depends on the limit or size of the particular deduction you’re claiming. A $6,000 deduction, for instance, would lower your taxable income by $6,000. To see a list of deductions, visit the IRS's Credits and Deductions for Individuals webpage.

Keep in mind that deduction limits vary based on IRS rules and are always subject to change. It’s a good idea to visit IRS.gov or check in with a tax professional for the latest information.

What is a tax credit?

While a deduction can help lower your taxable income, a tax credit directly lowers your tax liability, dollar-for-dollar. So let’s say you end up owing $5,000 in taxes this year, and you’re eligible for a $2,000 tax credit. The tax credit would lower your tax bill to $3,000.

Similar to tax deductions, you might not qualify for every tax credit you come across. So be sure to get the details for any credits you wish to claim from the IRS or a professional tax preparer.

A closer look at how a tax credit works

There are two different types of tax credits: nonrefundable and refundable.

A nonrefundable tax credit can only reduce the amount of taxes you owe. Any unused portion of the credit won’t be refunded to you.

For example, say you owe $500 in taxes, and you qualify for a $2,000 nonrefundable credit. You could use $500 of that $2,000 credit to bring your tax bill to zero, but you wouldn’t receive the $1,500 that’s left over in the credit ($2,000 - $500). In other words, while a nonrefundable credit could reduce your tax liability to zero, it cannot generate a refund - generally, any unused amount of a nonrefundable credit is forfeited.

Some examples of a nonrefundable credit include the following:

• Foreign tax credit
• Adoption tax credit
• Qualified electric vehicle tax credit

On the other hand, with a refundable tax credit, any unused amount of the credit will be refunded to you. So sticking with the previous example: If you qualify for a $2,000 refundable credit and you owe $500 in taxes, the credit could bring your tax bill down to $0 and the remaining $1,500 ($2,000 - $500) would be refunded to you. A common example of a refundable credit is the Earned Income Tax Credit.

Parting thoughts

Because most tax deductions and tax credits are subject to eligibility requirements, the IRS typically expects certain documentations with your tax return to show that you’re qualified to claim them. This is why good tax recordkeeping is important.

Also keep in mind that the availability of any tax deduction or credit, along with their eligibility rules, is always subject to change, as Congress has the power to modify or eliminate them at any time. So it’s a good idea to check in with the IRS or a tax professional if you’re unsure about a certain deduction or credit.