Both tax credits and deductions can offer taxpayers some relief on their tax bill. They’re both designed to reduce your tax liability — but they work in different ways. While you’ve likely taken advantage of credits and deductions in the past, it can be helpful to understand how they work, and what their potential limitations are.
First, the Basics
A tax credit offers a dollar-for-dollar reduction in how much you owe on your taxes. If you receive a $500 tax credit, that $500 comes directly off your tax bill after your tax liability has been tallied up.
A tax deduction lowers your taxable income, meaning less of what you earn is subject to tax. A tax deduction is taken before your tax liability is calculated, and it does not provide a dollar-for-dollar reduction. Rather, the amount you save is based on your tax bracket — which means the same deduction will be worth different amounts to people in different tax brackets. For example, if you are in the 24% tax bracket, a $1,000 tax deduction would save you $240 off your tax bill.
While both have the potential to help you save, a tax credit’s dollar-for-dollar savings tends to make it more valuable than a deduction.
Based on 2023 tax rates, here’s an example of how a deduction and credit of the same amount would differ in value:
| |
Tax Deduction ($5,000) |
Tax Credit ($5,000) |
| Your Income |
$215,000 |
$215,000 |
| Tax Deduction |
$5,000 |
N/A |
| Your Income After Deduction |
$210,000 |
$215,000 |
| Tax Rate |
32% |
32% |
| Tax Liability1 (based on the progressive tax system) |
$41,000 |
$43,200 |
| Tax Credits |
N/A |
$5,000 |
| Final Tax Bill: |
$41,600 |
$38,200 |
Keep in mind that this is a simple example of how credits and deductions can impact your general tax liability, and does not represent all possible scenarios or tax-saving opportunities available to you. Depending on the circumstances, for example, a deduction may reduce your taxable income enough to drop you into a lower tax bracket, which may save you even more on your final tax bill.
The Lowdown on Deductions
One of the biggest decisions every taxpayer must make when filing their return is whether to itemize their deductions, or take the standard deduction option.
As a part of the 2017 Tax Cuts and Jobs Act (TCJA), the standard deduction nearly doubled — which means more taxpayers now benefit from taking the standard deduction. In 2020, for example, 87.3% of tax returns used the standard deduction, according to the IRS.2
Along with increasing the standard deduction, the TCJA also took away the personal exemption, and reduced what taxpayers could deduct using itemized deductions. Overall, these changes incentivize taxpayers to opt for the standard deduction as opposed to itemizing individual deductions. With these TCJA provisions set to expire after 2025, however, it’s possible we could see a decrease in standard deduction takers in the future.3
As a reminder, here are the 2023 standard deductions.4
| Filing Status |
Standard Deduction |
| Single or Married Filing Separately |
$13,850 |
| Married Filing Jointly |
$27,700 |
| Head of Household |
$20,800 |
The IRS allows taxpayers who are either 65 and older or blind to deduct an additional amount from their standard deduction.4
| Filing Status |
Additional Standard Deduction |
| Single or Head of Household |
+$1,850 |
| Married Filing Separately or Jointly |
+$1,500 |
What About Above-the-Line Deductions?
The IRS will allow you to deduct certain additional expenses, even if you choose to take the standard deduction. These are called “above-the-line” deductions, as they appear above line 11 of Form 1040 (where your adjusted gross income is calculated).
Some of the most common above-the-line deductions include:5
- Alimony paid to an ex-spouse (if your divorce occurred before January 1, 2019)
- Health savings account (HSA) contributions
- Contributions to retirement accounts, including your IRA and 401(k)
- Reasonable moving expenses if you’re moving for the military
- Costs associated with being self-employed
- Payments made toward student loan interest
- Teacher expenses
Are Deductions Different from Exemptions?
Similar to deductions, tax exemptions reduce how much of your income is subject to tax.
As we mentioned before, the TCJA eliminated the personal exemption, which was a certain amount (similar to the standard deduction) that people could use to exclude a portion of their income from their taxes. In 2017 (the last year the exemption was available), filers could exclude $4,050, in addition to filing exemptions for their spouse and dependents.6
There are still various income types, such as certain academic scholarships or retirement income, that can be tax-exempt. With these types of exemptions, the qualifying income is not included as part of the person’s taxable income.
All About Tax Credits
Yes, tax credits have the potential to be more valuable — but they may not be available to everyone due to their qualifications and income restrictions. For example, the commonly claimed Child Tax Credit includes a $400,000 income limit for joint filers, or $200,000 for single filers for the 2023 tax year, in addition to other qualifiers.7
Other popular tax credits include:
Refundable vs. Non-Refundable Tax Credits
Tax credits typically fall into one of two categories: refundable or nonrefundable.8
Say your tax bill is relatively low and you have a tax credit that exceeds your total tax bill. If the tax credit is refundable, you may use it to take your tax bill into the negative — meaning the IRS would send you a refund check for the remaining credit amount.
Imagine you receive a $2,000 refundable Child Tax Credit, but your tax bill is only $1,000. Your tax bill would be brought down to $0, and the IRS would issue you a check for the remaining $1,000.
On the other hand, nonrefundable tax credits do not allow you to receive a refund for the amount of the credit that extends beyond your tax bill. If your tax bill is that same $1,000 and you have a nonrefundable tax credit for $2,000, your tax bill will drop to $0, but you wouldn't receive a refund for the remaining tax credit amount.
It’s worth noting that the America Opportunity Credit (AOC) is considered a partially refundable tax credit. The AOC tax credit is for those who paid for qualifying education expenses on behalf of an eligible student during their first four years of higher education.8 In this case, taxpayers may get a refund of up to 40% (up to $1,000) of any remaining credit amount that exceeds their tax bill.
Make the Most of Your Tax Return
Tax season comes around every year, yet it never seems to get easier. The good news is, you could include applicable tax credits and deductions to potentially save significantly on your tax bill each year.
To ensure you’re taking full advantage of these savings opportunities, speak to your accountant or other tax professional about your tax questions, especially if there are any recent changes in your life, such as buying an electric vehicle, having a child, or paying for college. They could help you find opportunities to minimize your tax bill now, and perhaps in the coming years as well.
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