The value of a tax credit depends on the nature of the credit. Certain types of tax credits are granted to individuals or businesses in specific locations, classifications, or industries. To understand the difference, consider a $1,000 tax credit versus a $1,000 tax deduction. Not every tax deduction requires you to itemize your deductions in order to claim it.

• Offer pros and cons are determined by our editorial team, based on independent research.
• Tax credits reduce your tax bill dollar for dollar and may even increase your refund.
• Your income tax bracket determines the tax rate you pay on various chunks of your income.
• So if you owe taxes the next year, you can claim more of that $2,000 credit.

But the government would send you the remaining $1,000 if the tax credit was refundable. They’re treated just as though you made a payment to the IRS. Tax credits might be refundable, partially refundable, or nonrefundable.

A big decision about tax deductions

“Every dollar that reduces your AGI reduces your taxable income, but it may also help you qualify for other deductions,” according to TaxAct. “Various credits are limited by your AGI as well. In some cases, an https://kelleysbookkeeping.com/what-is-the-meaning-of-understated-and-overstated/ adjustment may help you qualify for a tax credit or other tax benefits that you would not receive otherwise.” The alternative minimum tax (AMT) disallows the standard deduction and some itemized deductions.

Itemizing your deductions generally makes the most sense if your total deductible expenses are higher than the standard deduction. Medical and dental expenses are only deductible to the extent that they exceed 7.5% of your adjusted gross income (AGI). The mortgage interest deduction is limited to the interest paid on the first $750,000 of mortgages that are taken out after Dec. 16, 2017. This limit drops to $375,000 if you’re married and filing a separate return. The Child Tax Credit was a partially refundable credit but became refundable (up to $1,500 in 2022 and $1,600 in 2023) as a result of the Tax Cuts and Jobs Act (TCJA).

What’s the Difference Between Tax Credits and Tax Deductions?

If all else is equal, a tax credit will lower your tax bill more than a tax deduction of the same amount. That’s because a tax credit reduces your taxes dollar for dollar, whereas a tax deduction lowers the amount of income you pay taxes on. Tax deductions lower your taxable income and potentially reduce what you’ll pay in taxes as a result. Tax credits reduce your tax bill dollar for dollar and may even increase your refund.

The credit normally works out to a percentage of up to $3,000 in expenses for the care of one dependent or up to $6,000 for two or more dependents. The percentage you can claim decreases as your income rises. Most credits are nonrefundable, according to the Urban-Brookings Tax Policy Center. Others are partially or fully refundable, meaning that some or all of the credit can be applied as a tax refund. The American Rescue Plan Act updated this credit for tax year 2021. The age limit was increased to age 17 by the last day of the year.

More In Smart Tax Planning

Here are some examples of deductible expenses for tax year 2023. While some of them must be itemized, others (like the student loan interest deduction) are above-the-line deductions. You can claim above-the-line deductions as separate deductions even if you’re not itemizing your deductions. Importantly, adjusted gross income interacts with other areas of your tax return — meaning that, by reducing AGI, above-the-line deductions can help save money elsewhere. Ask a tax professional if you’re not sure what tax credits you might be eligible to claim.

• Having earned income is required, as the name of the credit suggests.
• The tax credit can be 20% of up to $10,000 in qualifying expenses related to education, or $2,000, for an eligible taxpayer, their spouse, or their dependent.
• Eligible taxpayers can claim these regardless of whether they itemize or take the standard deduction.
• Tax credits are generally more beneficial because they apply directly to the taxes owed and lower your tax bill.
• Another thing to remember is that you can’t claim a credit and a deduction for the same qualified expense.
• Taxes are calculated first, then credits are applied to the taxes you have to pay.

You won’t be able to make the most of nonrefundable tax credits that reduce the amount of taxes you owe to zero and still have dollars left over. Tax credits and tax deductions both decrease the total that you’ll pay in taxes, but they do so in different ways. A tax credit is a dollar-for-dollar reduction of the money you owe, while a tax deduction will decrease your taxable income, leading to a slightly Tax Credits Vs Tax Deductions lower tax bill. Refundable tax credits are the most beneficial credit because they’re paid out in full. This means that a taxpayer (regardless of their income or tax liability) is entitled to the entire amount of the credit, beyond a zero amount of tax due. So, for example, if the refundable tax credit reduces the tax liability to below $0, then the taxpayer is due a refund of that specific amount.

Tips for Lowering Your Tax Bill

Both tax credits and tax deductions are a welcome feature of tax time for any taxpayer. They both reduce money owed to the government in a given year. One of the most popular refundable tax credits is probably the Earned Income Tax Credit (EITC).

Some credits—called refundable credits—will even give you a refund if you don’t owe any tax. However, credits and deductions reduce tax liability in different ways. Tax credits are subtracted directly from a person’s tax liability; they therefore reduce taxes dollar for dollar. Credits have the same value for everyone who can claim their full value. The IRS will keep that $1,000 if the credit you claimed was nonrefundable. You’d gain no benefit from the tax credit if you didn’t owe any money to the IRS because there would be no tax bill for it to eliminate.