When you file tax returns, there are 2 ways to reduce the amount you owe to the government: tax credits and tax deductions. While these tax reduction methods might seem similar, there are some important distinctions between them. Here’s what you need to know about tax credits vs. deductions.
What is a tax credit?
A tax credit directly reduces your tax bill. For example, if you’re eligible for a $1,000 tax credit and owe $2,000 in taxes, the tax credit would cut the amount of taxes you owe to $1,000.
For most tax credits—such as the Child and Dependent Care Tax Credit and the American Opportunity Tax Credit—there are eligibility requirements you need to meet to qualify, which could include income and/or tax-filing status. These can change every year, so check the qualifications for the tax year you’re filing.
Another important thing to know about a certain tax credit is whether it’s refundable, nonrefundable, or partially refundable. If the credit is refundable or partially refundable, that means you might receive cash back from the IRS, even if you don’t have a tax bill or the tax credit cancels out all of what you owe and then some. If a tax credit is nonrefundable, it can cancel out what you owe but any leftover tax credit amount won’t lead to a refund.
Common tax credits
Many people qualify for these credits, all of which could help lower your tax liability if you meet the eligibility requirements.
- Earned Income Tax Credit: This refundable credit is intended to help low- and moderate-income workers, especially those with dependent children.
- Child and Dependent Care Credit: This nonrefundable credit is for helping parents—and certain caregivers of adults who can’t care for themselves—offset the cost of care while the caregivers work or look for work.
- American Opportunity Tax Credit: This partially refundable tax credit for qualified education expenses could help ease the burden of college costs during a student’s first 4 years of higher education. Students might also qualify for the nonrefundable Lifetime Learning Credit.
What is a tax deduction?
A tax deduction reduces the amount of income on which you have to pay taxes. You might be able to deduct certain expenses, like medical costs, mortgage interest, and charitable contributions, if you itemize your deductions (meaning you add up eligible expenses and reduce your income by that total).
That’s in contrast to taking the standard deduction—a flat amount by which all eligible taxpayers could reduce their income, based on their filing status. For the 2023 tax year, the standard deduction for most people is as follows:
- Single filer/married filing separately: $13,850
- Head of household: $20,800
- Married, filing jointly: $27,700
The IRS says nearly 90% of taxpayers choose to take the standard deduction.1 But if you’ve spent a lot on health care, state and local taxes, and/or other itemizable categories, it might make more sense to itemize, as you can’t take the standard deduction and itemize in the same tax year. Still, there are some deductions you may claim even if you claim the standard deduction. (More on this below.)
Just remember that each dollar you claim as a deduction reduces your taxable income, not your tax bill, by a dollar. In other words, a $1,000 deduction doesn’t lead to a $1,000 refund. Instead, if your income is $75,000, and you have $15,000 worth of deductions, you will only be taxed on $60,000. The rate at which you are taxed is based on your tax bracket. (Learn more about how tax brackets work.)
You could potentially deduct all of your tax liability down to $0, but you couldn’t turn deductions into refunds. Like some tax credits, tax deductions are nonrefundable.
Common tax deductions
Remember when we said there are deductions you can take even if you don’t itemize? These are some of them.
- Health savings account (HSA): You may deduct contributions you’ve made to your HSA to reduce taxable income.
- Individual Retirement Accounts (IRAs): If you contribute to a traditional IRA, you may be able to deduct the total amount of your contributions, up to the contribution limit, if your income is under the maximum allowed. Contributions to Roth IRAs, though, aren’t deductible.
- Student loan interest: Taxpayers below a certain income threshold may deduct up to $2,500 in student loan interest they paid that calendar year.
How to claim tax deductions and credits
There are different processes to follow to claim each tax break. Some of these deductions and credits are part of Form 1040, the standard form for filing tax returns. These include the Earned Income Tax Credit and the Educator Expense deduction. Other deductions and credits, such as the Child Tax Credit, require you to file a separate form along with your Form 1040. Check with IRS.gov or consider consulting a tax pro for more info.
Is there a limit to the number of deductions and credits you can claim?
While the IRS doesn’t limit the number of credits and deductions you can claim per year, many tax breaks come with their own income limits and eligibility requirements—and many are mutually exclusive. That means you can’t get 2 breaks for the same expense. For example, you can’t claim both the American Opportunity Tax Credit and the similar Lifetime Learning Credit for the same student.