February 24, 2023 | Posted in:

Understanding Tax Credits Versus Deductions

Every industry and profession has common terms that are used so often those of us in the business often forget that most people do not have the depth of understanding that a person working within the tax code might have. One of these areas is understanding the differences between the tax terms “deductions” and “credits”. Is one better than the other?

Tax credits are some of the most valuable tools around to help cut your tax bill. But figuring out how to use these credits on your tax return can get complicated very quickly.

Here’s an easy-to-follow breakdown.

Top line explanation of credits vs. deductions

Dollar for dollar, a credit is worth more to you than a deduction. Why? A credit is a direct reduction in tax, while a deduction reduces the amount of income that gets taxed. Here is a simple chart showing the difference.

Assuming you have a $2,000 tax credit, how large a deduction would you need to be indifferent?

Your marginal tax rate Deduction required to equal $2,000 tax credit
10% 20,000
15% 13,333
25% 8,000
28% 7,143
33% 6,061
35% 5,714

Note: This example does not account for the possibility that the deduction could move you into a lower tax rate nor does it consider other tax factors.

Tax credit vs. tax deduction: Understanding the difference through examples

To help illustrate the difference between a credit and a deduction, here is an example of a single taxpayer making $50,000 in 2022.

  • Tax Deduction Example: Gee I. Johe earns $50,000 and owes $5,000 in taxes. If you add a $1,000 tax deduction, he’ll decrease his $50,000 income to $49,000, and owe about $4,800 in taxes.
    Result: A $1,000 tax deduction decreases Gee’s tax bill by $200, from $5,000 to $4,800.
  • Tax Credit Example: Now let’s assume G.I. Johe has a $1,000 tax credit versus a deduction. Mr. Johe’s tax bill decreases from $5,000 to $4,000, while his $50,000 income stays the same.
    Result: A $1,000 tax credit decreases your tax bill from $5,000 to $4,000.

In this example, your tax credit is five times as valuable as a tax deduction.


4 Factors of tax credit vs. tax deduction

So on the surface it appears that a credit is worth more than a deduction to you. But the real answer is….it all depends. Here are some things to consider:

Your marginal tax rate.

A similar deduction is worth more to someone in the 35% tax range than it is to someone being taxed at 10%.

How much is it?

A large deduction could be worth more to you than a small credit. In combination with your marginal tax rate, a deduction could be worth a lot more to you than a credit.

Are there phase-outs?

Most credits and deductions phase out when your income is over certain amounts. You must consider this when determining the true tax benefit. Consider that a deduction that reduces your income could make other credits and deductions that were previously phased out now available to you.

Is the credit refundable?

Some credits get a “bonus”. While you cannot deduct your income below zero, you can sometimes receive credits that create a refund even if you owe no tax. Credits that have this “bonus” feature are called “refundable” credits.


Common tax credits and tax deductions

Included for your reference are some of the more common deductions and credits. Thankfully, professional tax software allows for quick analysis of the choices.

Common Credits Common Deductions
  • Earned Income Tax Credit
  • Child Tax Credit
  • Adoption Credit
  • American Opportunity Credit
  • Lifetime Learning Credit
  • Dependent Care Credit
  • Retirement Saving Credit
  • Elderly Disabled Credit
  • Foreign Tax Credit
  • General Business Credits
  • Medical Expenses
  • Charitable Contributions
  • Property Taxes
  • State Income Taxes
  • Mortgage Interest
  • Standard Deductions
  • Alimony paid (through 2018)
  • IRA and HSA contributions
  • Qualified Education Expenses

Note: Many of these credits and deductions are not a permanent part of the tax code. Some have been repeatedly extended while others have or will expire without congressional action.


Too good to be true?

Credits are generally worth much more than deductions. However there are usually several hurdles you have to clear before being able to take advantage of a credit.

To illustrate, consider the popular child tax credit from last year.


Hurdle #1: Meet basic qualifications

You were able to claim a $2,000 tax credit for each qualifying child you have on your 2022 tax return. The good news is that the IRS’s definition of qualifying child is fairly broad, but there are enough nuances to the definition that Hurdle #1 could get complicated. And then to make matters more complicated…

Hurdle #2: Meet income qualifications

If you make too much money, you can’t claim the credit. If you’re single, head of household or married filing separately, the child tax credit completely goes away if you exceed $240,000 of taxable income. If you’re married filing jointly, the credit disappears above $440,000 of income. And then to make matters more complicated…

Hurdle #3: Meet income tax qualifications

To claim the entire $2,000 child tax credit, you must owe at least $2,000 of income tax. For example, if you owe $3,000 in taxes and have one child that qualifies for the credit, you can claim the entire $2,000 credit. But if you only owe $1,000 in taxes, the maximum amount of the child tax credit you could claim is $1,400.


While this child tax credit is just one example to help highlight the difference, it also applies to other popular credits such as the Earned Income Tax Credit, the Child and Dependent Care Credit, education credits, the new Clean Vehicle Credit, and many more.


Take the tax credit…but get help!

The bottom line is that tax credits are usually more valuable than tax deductions. But tax credits also come with lots of rules that can be confusing. Please call to schedule a tax planning session to make sure you make the most of the available tax credits for your situation.



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