What’s the Difference between a Tax Credit vs. Tax Deduction?

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.

Table of Contents
  1. Tax Credit vs. Tax Deduction
  2. Claim Standard or Itemized Deductions?
  3. $1,200 Stimulus Check

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.

So in a hypothetical scenario in which 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 2020:

  • Single: $12,400
  • Married filing jointly: $24,800
  • Married filing separately: $12,400
  • Head of household: $18,650

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 $12,400 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. The CARES Act made cash donations up to $300 an “above-the-line” deduction so you can claim it even if you take the standard deduction. You can claim up to $300 in cash contributions this way.

$1,200 Stimulus Check

The $1,200 stimulus check in the CARES Act was an advance on a refundable tax credit. Now that we know what a refundable tax credit is, let’s cover the “advance” part. It simply means that the IRS will send you a check for the tax credit now and then sort out the details next year when you do your taxes.

What gets tricky is that the tax credit is based on 2020 tax year information. This is information they won’t get until you file your taxes in 2021. But they need to send the checks today… so what’s the solution?

The amount of the check they send to you today is based on 2018 or 2019 tax information.

Then, after you file your taxes in 2021 for this year, they will adjust your tax refund accordingly. They have said that if they overpaid, they won’t claw back any money. If they underpaid, you should see the difference added to your tax refund.

Now you know the difference between a tax credit and tax deduction!

Other Posts You May Enjoy:

What Is the Stepped-Up Basis Loophole?

The step-up basis loophole says that when assets are inherited the heir receives the asset at market value. If they sell the asset they will only pay capital gains on any growth that took place after they took ownership.

TaxSlayer Review 2021: Features, Prices, Pros and Cons

TaxSlayer offers low cost, online tax prep. Their free version isn't as comprehensive as other platforms, for example it doesn't support dependents. However, their paid plans are less expensive than their competitors.

What is the Effective Tax Rate?

Your income is not all taxed at the same rate. Instead, different levels of income are taxed at different rates. Your effective tax rate is not your tax bracket, but is probably best described as an "average" tax rate pertaining to the federal income taxes you pay.

What are Donor-Advised Funds?

Donor-advised funds are perfect for those who give regularly to charities but not enough to take advantage of itemizing their deductions. These funds allow you to group many year's worth of donations into one year to optimize your tax deductions.

About Jim Wang

Jim Wang is a thirty-something father of three who is a frequent contributor to Forbes and Vanguard's Blog. He has also been fortunate to have appeared in the New York Times, Baltimore Sun, Entrepreneur, and Marketplace Money.

Jim has a B.S. in Computer Science and Economics from Carnegie Mellon University, an M.S. in Information Technology - Software Engineering from Carnegie Mellon University, as well as a Masters in Business Administration from Johns Hopkins University. His approach to personal finance is that of an engineer, breaking down complex subjects into bite-sized easily understood concepts that you can use in your daily life.

One of his favorite tools (here's my treasure chest of tools,, everything I use) is Personal Capital, which enables him to manage his finances in just 15-minutes each month. They also offer financial planning, such as a Retirement Planning Tool that can tell you if you're on track to retire when you want. It's free.

He is also diversifying his investment portfolio by adding a little bit of real estate. But not rental homes, because he doesn't want a second job, it's diversified small investments in a few commercial properties and a farm in Illinois via AcreTrader.

Reader Interactions

Leave a Comment:

Comments

About the comments on this site:

These responses are not provided or commissioned by the bank advertiser. Responses have not been reviewed, approved or otherwise endorsed by the bank advertiser. It is not the bank advertiser's responsibility to ensure all posts and/or questions are answered.

  1. Lisa says

    single, no dependents. I usually get back 1100 in federal and pay state every year. Will I get a federal return because of the stimulus?

    • Jim Wang says

      It depends on your income – if you earn (adjusted gross income) less than $99,000 then you’ll get a larger check.

  2. Eric Baker says

    Eric

    So, my situation is not that unique I just want to know if I didn’t claim my son on 2019 taxes but will do so on 2020…how will that affect my taxes since I didn’t receive the extra dependent money on my stimulus check?

  3. Craig Whitman says

    Hi,
    My son filed his 2019 tax returns, but mistakenly had the wrong address (he’d just moved). He has not received his stimulus check (he qualifies) and can’t get the info from Get My Payment, probably due to the mix-up with his address. He has not been successful calling IRS. If he waits until he files his return for 2020, is there a way to get his check at that time, in addition to his tax refund for 2020? For example, will there be something on the return that alerts IRS that he didn’t get his check?
    Thank you!

  4. Ana says

    I claimed my daughter who is 17 as a dependent for 2019 Taxes. But was not qualified for the stimulus. If she files for 2019 & 2020 would she be qualified then and get a increase on her refund?

    • Jim Wang says

      She would get it after she files her 2020 tax year (in April 2021) because the stimulus check was created for the 2020 tax year.

  5. Maggie says

    Ok so I actually understand taxes very well. But our government and the IRS tend to make things sound confusing, and then the media doesn’t always report the full details when big things like this happen.
    I believe you might have answered this above but I just want to verify I understand correctly.
    So they created a new credit for the stimulus checks, that we’re getting now instead of next year, correct? Which means if nothing else has changed that would affect me tax wise, then I’ll still get the same refund I’ve been getting, correct?

  6. Matt says

    Last year I got $3,200 back, but had $4,000 in child tax credits, for my two children. With next year, all else being equal, will I then owe $800, because the refundable child tax credit has essentially already been given to me?

    • Jim Wang says

      The child tax credits you go were for last year, you’ll get them again this year depending on how much your income changes.

  7. Donna says

    So it was clarified that if we normally get a refund, we still will even if we got a stimulus check, (and please tell me if I got that wrong). My son who is 19 now will be 20 in 2021. He will have no income cause he doesn’t work yet due to special needs. My question is, can he file a tax return showing no income for 2020, and get a $1200 refund because of the tax credit from Cares Act?

    • Jim Wang says

      As far as I understand it, yes. The tricky part will be – you will have to figure out whether you get more from claiming him as a dependent vs. him filing his own return.

  8. Kel says

    If our combined income could pass 150k for 2020 but was below in 2019 how can we calculate what is owed? Also, what if we claim 3 dependents in 2019 and 4 in 2020.

    • Jim Wang says

      They will just use your 2019 information and send you a check based on that. If you are due more, they’ll make up for it when you file your taxes next year.

      • Kel says

        Thank you. So, if we pass the $150k mark in 2020 will we have to pay a portion back if our 2019 income was below 150? How can we calculate what we would owe?

  9. Randi Moxley says

    Ok, so I’m super duper confused… I’m a single Mom with 2 kids (16 and 6 y/o), and I work 2 jobs and my AGI is usually $29-30K. I usually get anywhere from $7,000-8,000 back on my tax refund check, because I file single or head of household.

    My income isn’t going to change this year and might even be a few thousand less, or just about the same. So I got $2,200 from the 1st round of stimulus checks and if I get another $2,200 for the 2nd round of stimulus checks, am I still going to get my full refund check in February 2021?

    I see you’re answering similar questions on here, but I’m not understanding your answers. You keep saying, no that we’ll still get our usual amount on our tax refunds, but how is that so? Will it still be the same for the 2022 tax refunds as well? I’m just not understanding how the stimulus is a “tax credit” and it won’t affect our tax refunds at all. Please explain in detail if you don’t mind, because I have coworkers also asking the same questions. Thanks so much! God Bless!

    • Jim Wang says

      Hi Randi – Yes, your tax refund will not be affected by the check. The law that created the stimulus check also created a new one-time tax credit of $2,200 (in your case) for you. The law also made it so that they paid the credit out right now, rather than waiting until you file your tax return next April.

  10. Chris says

    A little outside the lines here, but still relevant. Why were adult dependants, not living with me, excluded from stimulus checks? After al,l I had to pay half their annual income to qualify as a dependant. Would that not show they need the stimulus as much as anyone else?

    • Jim Wang says

      I don’t know the reasoning why they excluded dependents that were 17 or older – it doesn’t make sense to me since to qualify as a dependent, you’d have to have supported them at least 50%.

See More Comments

As Seen In: