Tax Deductions versus Tax Credits. What Is the Difference?

Paying taxes on income is a fact of life, but the amount of taxes paid by a taxpayer may be reduced by tax deductions or credits, and in some cases the IRS may actually pay the taxpayer. However, the effect of a tax deduction is different from that of a tax credit, so this article will focus on the difference and how each affects a taxpayer’s liability.

What Is a Tax Deduction?

A tax deduction reduces a taxpayer’s taxable income, thus reducing the amount of tax that is due on income. There are basically two types of tax deductions on a federal income tax return (Form 1040):

Deductions that affect Adjusted Gross Income
Deductions that reduce Taxable Income

The first type of tax deduction is subtracted from the taxpayer’s income in order to calculate his Adjusted Gross Income (AGI). It is possible for a taxpayer to have a loss that will result in a negative AGI. This may be the result of a business loss or tax deductions that exceed the taxpayer’s income. Deductions that affect a taxpayer’s AGI may include the following:

Educator expenses
Health Savings Account deductions
Moving expenses
One-half of the self-employment tax
Self-employed retirement plans
Self-employed health insurance premiums
Penalties on early withdrawal of savings
Alimony
IRA contributions
Student loan interest
Tuition and fees

The second type of tax deduction reduces the taxpayer’s AGI in order to calculate taxable income. However, unlike the AGI, a taxpayer’s taxable income cannot be less than zero.

The primary tax deductions that reduce AGI are the standard deduction and personal exemptions. The standard deduction is based on the taxpayer’s filing status (single, married filing jointly, head of household, married filing separately, etc.). Personal exemptions are calculated by multiplying a fixed amount by the number of tax exemptions claimed on the return.

As an alternative to the standard deduction a taxpayer may choose to itemize deductions on Schedule A, and this may be a wise choice if itemized deductions exceed the standard deduction. Itemized deductions may include the following:

Medical and dental expenses
State and local taxes paid
Sales taxes
Real estate taxes
Taxes on new motor vehicles
Home mortgage interest
Mortgage insurance premiums
Gifts to charity
Casualty and theft losses
Job expenses
Certain miscellaneous deductions

What Is a Tax Credit?

Unlike a tax deduction that reduces taxable income, a tax credit actually reduces a taxpayer’s tax liability. For instance, a taxpayer may have a tax liability of $1,000, but since he had $1,100 withheld from his paychecks during the year, the payments constitute a credit that reduces his tax liability to zero and actually results in a refund of $100.

There are two basic types of tax credits:

Nonrefundable credits
Refundable credits

Nonrefundable credits can reduce a taxpayer’s tax liability, but they will not reduce the liability below zero. For instance, a taxpayer may have child care expenses in the amount of $800 but a tax liability of only $600. The credit will reduce the tax liability to zero and no further.

Nonrefundable credits may include the following:

Foreign tax credit
Child and dependent care expenses
Education credits
Retirement savings contributions
Child tax credit
Credits from other forms or schedules

Employees who live in one state and work in another are also familiar with nonrefundable tax credits. A taxpayer may be able to take a tax credit against the state income tax where he lives for taxes paid to another state. But this is a nonrefundable credit because the state tax liability cannot be reduced below zero.

Refundable credits, on the other hand, not only reduce the taxpayer’s liability, the taxpayer will receive a refund if the credits exceed the taxpayer’s tax liability. As noted earlier, taxes that have been withheld from an employee’s paycheck are actually refundable credits.

In addition to withheld taxes, refundable credits may include the following:

Estimated tax payments
Earned income credit
Additional child tax credit
American opportunity education credit
Premium tax credit under the Affordable Care Act
Excess social security tax withheld

Tax Deductions and Tax Credits Can Reduce Tax Liabilities

No one says that they really like to pay taxes, so reducing tax liabilities is something that most taxpayers are interested in. Understanding the difference between a deduction and a credit can help to clarify the reporting process, so that a taxpayer only needs to pay what is necessary. In addition, some taxpayers may actually receive payments from the IRS if they have tax credits that exceed their tax liability.