“What’s the difference between tax deductions and tax credits?”
It’s a fairly common question. People often hear things about writing something off, taking a deduction, qualifying for a tax credit, and so on, but they’re not always clear on exactly what it’s referring to.
While both can save you money—sometimes a significant amount—on your taxes, there’s a big difference between tax deductions and tax credits. They function differently and affect your numbers differently, and each must be claimed in its own way on your return.
Tax Deductions
A tax deduction is something that reduces your total taxable income. It’s a tax-deductible expense or exemption that gets subtracted from your earnings for the year.
For example, many people claim the standard deduction on their personal taxes (rather than itemized deductions). In 2022, the standard deduction is $12,950 for single taxpayers and $25,900 for married couples. So, if you’re a couple with a household income of $150,000 and you take the standard deduction, your taxable income is reduced to $124,100.
Tax Credits
A tax credit, on the other hand, is subtracted from your total taxes owed for the year—not from your taxable income.
A common example is the Child Tax Credit, which varies depending on your income and the age of your child(ren). Say you had a qualifying 5-year-old child in 2021 that allowed you to claim a $3,600 Child Tax Credit. If your total tax bill came out to $1,200, after you take the credit, you’d be due a $2,400 refund.
Is a Tax Deduction or a Tax Credit Better?
Both tax deductions and tax credits are beneficial to the taxpayer. However, tax credits are worth more. As you can see from the examples above, a tax credit is worth its face value to you, but a tax deduction is worth less than its face value.
A $500 deduction reduces your taxable income by $500. How much money that saves you depends on your tax bracket. Again, if you’re a married couple with a household income of $150,000 in 2022, you’re in the 22% tax bracket. The deduction would therefore reduce your taxes owed by $110; it’s worth 22% of its dollar value.
In contrast, a $500 credit means that $500 is directly subtracted from your taxes owed. Again, a credit is worth its full face value.
Hopefully, this clarifies the difference between tax deductions and tax credits. Working with a professional tax preparer is the best way to ensure you benefit from all of the deductions and credits you’re entitled to.
