Do you know the difference between a tax credit and a tax deduction?
If so, you may be in the minority compared to most Americans because one of the biggest misunderstandings about taxes is the idea of a tax credit vs. a tax deduction.
They both put your money in your pocket but in vastly different ways. And knowing the difference can help you get a bigger tax refund.
🔃Updated January 2023 with the latest figures for tax year 2022. While it is the year 2023, we are preparing our taxes for the previous year so we’ve kept the figures for tax year 2022 to avoid confusion. We also removed mentions of the CARES Act tax changes which no longer apply.
Tax Credit vs. Tax Deduction
Here’s the difference between a tax credit and a tax deduction:
- A tax credit reduces how much tax you owe to the IRS and is a dollar for dollars reduction in tax liability. The Child Tax Credit is worth up to $2,000 per qualifying child and if you qualify, it will reduce how much you owe on your taxes by $2,000.
- A tax deduction reduces how much of your income is subject to taxation, and usually only if you itemize your tax deductions. Charitable contributions are tax deductions so if you make a $2,000 donation to a qualifying charity, you reduce your taxable income by $2,000. Your taxes will go down based on your tax bracket. If you’re in the 24% tax bracket, your taxes will be reduced by $480.
In a hypothetical scenario where you could get either a $2,000 tax credit or a $2,000 tax deduction, you want the tax credit. It reduces your tax liability the most.
With tax credits, there’s also another distinction – is the tax credit refundable?
Refundable means that you will get the full value of the credit, even if your tax liability is reduced to below zero. For example, the Child Tax Credit is refundable so even if you owed very little in taxes, and the credit put your tax liability in the “negative,” where the IRS owes you money, you would get all of the credit.
Let’s say you qualify for a $2,000 Child Tax Credit and you owed $1,000, then the IRS would send you $1,000. If the Child Tax Credit were not refundable, you would get nothing.
There’s one more added wrinkle, the Child Tax Credit is partially refundable up to $1,400 per child. So if you qualified for the full $2,000 of credit but you only owed $200 in taxes, you wouldn’t get $1,800 – you would only get $1,400 back.
Claim Standard or Itemized Deductions?
When you file your taxes, you often have to make a big decision – do I claim the standard deduction or should I itemize my deductions?
With a tax credit, you get it no matter what. No decision required.
With a tax deduction, you only get it if you itemize your deductions. When you file your taxes, you can always claim a standard deduction. The standard deduction is meant as a catch-all and you don’t have to do anything extra to get it – everyone can take it.
The amount you can deduct will be based on your filing status for 2022:
- Single: $12,980
- Married filing jointly: $25,900
- Married filing separately: $12,950
- Head of household: $19,400
If you have a series of deductions that, in total, exceed the standard deduction then you will want to itemize them on a Schedule A. In other words, let’s say you’re a single filer, if you think you have more than $12,980 in total tax deductions, you will have to itemize them to get the full deduction. This also means you have to retain the paperwork and proof, just in case your tax return is audited. No proof required for a standard deduction.
You almost always want to use the method that gets you the highest tax refund (don’t claim the standard deduction because you think you’ll get audited, it’s extremely unlikely) but you can see now why a tax credit is so much better. 🙂
But when it comes down to the numbers – this is why a tax deduction is less attractive than tax credit – you need a sum total of deductions greater than the standard deduction. With a tax credit, you just get it if you qualify.
Some tax deductions are “above-the-line” deductions, which means you can claim them even if you don’t itemize your deductions. One common above the line deduction is if you’re a teacher and pay for some expenses out of pocket, known as “educator expenses.”
Now you know the difference between a tax credit and tax deduction!