U.S. Markets closed

What's the Difference Between a Tax Deduction and a Tax Credit?

Kailey Fralick, The Motley Fool

You're offered the choice between a $1,000 tax deduction or a $1,000 tax credit: Which do you take? If you're not familiar with the difference between tax deductions and tax credits, you won't know which represents the better deal for your tax return. 

They both reduce the amount of your hard-earned cash that goes to the government, but in different ways. Below, I'll explain how the mechanics of tax deductions and tax credits differ, as well as walk you through some of the most popular ones.

Two doors, a yellow and a blue

Image Source: Getty Images

What is a tax deduction?

Tax deductions reduce your amount of taxable income in the eyes of the IRS, or in other words, how much money the government will consider in deciding what rate to use in taxing your income and how much cash to apply that rate to in tallying up your tax bill.

If you take a $1,000 tax deduction, your taxable income for the year will be reduced by $1,000. Depending on your annual income and how many tax deductions you qualify for, you could wind up in a lower income tax bracket, resulting in the government taxing a smaller percentage of your earnings.

Even if your tax deductions don't change the bracket you occupy, allowing you to be taxed at a lower rate, they can still reduce the amount you owe in tax, by reducing your taxable income. You can figure out how much you're saving by multiplying the value of the deduction by the income tax bracket you're in. For example, a $1,000 tax deduction would be worth $220 off the tax bill for someone in the 22% income tax bracket.

When it comes time to do your taxes, you'll have the choice between a standard deduction and itemized deductions. The standard deduction may change from year to year and depends on your tax filing status. Individuals will get a standard deduction of $12,000 when they file their taxes for the 2018 tax year, as will married couples filing separately. Married couples filing jointly have a standard deduction of $24,000 and heads of household have a standard deduction of $18,000. These numbers are slightly higher for the elderly, blind, and disabled.

It's worth noting you can't take the standard deduction and itemize deductions at the same time. You have to choose one or the other. The only time it makes sense to forego the standard deduction, instead itemizing your deductions, is when you believe the other tax deductions you qualify for exceed the value of the standard deduction. Tax-filing software will automatically calculate whether a standard deduction or itemized deductions is your better option, so you don't need to worry about choosing if you go that route.

An example: For people who are self-employed and have a number of business expenses to write off, itemized deductions may make sense.

Other popular tax deductions filers can write off their taxbale income include medical expenses exceeding 7.5% of your adjusted gross income (AGI), charitable contributions, state income and property taxes, and mortgage interest.

What is a tax credit?

Tax credits reduce the amount of taxes you owe, but instead of doing so by reducing your taxable income, tax credits reduce your actual tax liability, acting as a dollar-for-dollar reduction of your tax bill. 

If you qualify for a $1,000 tax credit, the total in taxes you owe will be reduced by $1,000. So to answer the question at the start of this article: You're much better off taking the $1,000 tax credit over the $1,000 tax deduction.

When it comes to tax credits, there are two main types: refundable and nonrefundable. Refundable tax credits offer the better deal, if you can take advantage of them, because if their value exceeds your tax liability, the government will actually refund you the difference. Nonrefundable tax credits may reduce your tax liability to zero, but the government does not refund you any excess once you hit zero.

One of the most common refundable tax credits is the earned income tax credit (EITC). It's designed to help lower-income families, especially those with dependent children, save on their taxes. The maximum income requirement to use in qualifying for the EITC depends on your tax filing status and your number of qualifying children. This tax credit could be worth $519 for the 2018 tax year to couples with no children, $3,461 to families with one child, $5,716 to families with two children and $6,431 to families with three or more children. If these amounts exceed your total tax liability for the year, the government will give you the difference in your tax refund. This means it's still worth filing a tax return if you will qualify for this benefit, even if your income for 2018 is less than $12,000, meaning you're not legally required to file a tax return.

Tax credits are given for life circumstances like having children, adopting, pursuing higher education, or caring for an elderly parent. If you're filing your taxes with a software program, it should ask you a series of questions to determine what tax credits you qualify for. If you receive any tax credits, they will automatically be taken off of your tax liability for the year.

While most tax software takes care of the complex math for you, it still pays to understand how tax deductions and tax credits work so that you have an idea of how they impact your taxes. It's also a good idea to explore what sorts of expenses or life events qualify for a tax break so you can plan to maximize them. You could very well uncover a credit or deduction you didn't even know was available to you.

More From The Motley Fool

The Motley Fool has a disclosure policy.