What is the Difference Between Tax Credits and Tax Deductions?

When it comes to tax planning, knowing the difference between tax credits and tax deductions can make a big difference in how much a business or individual pays in taxes. Both are designed to reduce your tax burden but they work differently. Tax credits give you a dollar for dollar reduction in the amount of tax owed. Tax deductions lower your taxable income which can then reduce your overall tax liability depending on your tax bracket.

This article will break down the differences between tax credits and tax deductions and include examples of each. We’ll also cover two types of tax credits—refundable and nonrefundable—to help you understand how they apply to you.

Can Tax Credits Lower Your Tax Liability?

Yes, a tax credit reduces the amount of tax you owe. For example if your total tax bill is $5,000 and you get a $1,000 tax credit, your new tax bill is $4,000. Because tax credits reduce your tax bill directly they can make a major difference in reducing your tax liability.

Types of Tax Credits

Refundable tax credits not only reduce your tax liability but can also result in a refund if the credit exceeds the taxes owed. For example, if you owe $1,000 in taxes and qualify for a $1,200 refundable credit, you would receive a $200 refund. These credits are highly advantageous because they provide a financial benefit even if you have little or no tax liability.
Examples of Refundable Tax Credits:
- Earned Income Tax Credit
- Child Tax Credit (partially refundable)
- American Opportunity Tax Credit (partially refundable)
- Premium Tax Credit
Nonrefundable tax credits can reduce your tax liability to zero, but they do not result in a refund if the credit amount exceeds your tax liability. For example, if you owe $1,000 in taxes but qualify for a $1,200 nonrefundable credit, your liability becomes zero, but the remaining $200 cannot be refunded.
Examples of Nonrefundable Tax Credits:
- Foreign Tax Credit
- Child and Dependent Care Credit
- Lifetime Learning Credit
- Saver’s Credit
- Credit for the Elderly or Disabled
- Adoption Credit

Can Tax Deductions Reduce Taxable Income?

Unlike tax credits, tax deductions lower your taxable income, which in turn reduces your overall tax liability. The value of a deduction depends on your tax bracket. For instance, if you are in the 22% tax bracket, a $1,000 deduction would reduce your taxes owed by $220.

Examples of Tax Deductions

Tax deductions come in several forms, including:

Standard Deduction The standard deduction is a fixed amount that taxpayers can subtract from their taxable income. The amount varies depending on your filing status and is adjusted annually for inflation.
Itemized Deductions Taxpayers who choose to itemize their deductions instead of taking the standard deduction can claim specific expenses, including:
- Medical expenses
- State and local taxes paid
- Home mortgage interest
- Charitable contributions
Business-Related Deductions For business owners, several deductions can help reduce taxable income, such as:
- Qualified Business Income Deduction: Allows eligible businesses to deduct up to 20% of their qualified business income.
Other Deductions
- Student Loan Interest Deduction
- Educator Expense Deduction
- Alimony Payments (for divorces finalized before 2019)
- Moving Expenses (for active-duty military members)
- HSA Contributions to a Health Savings Account can be deducted from taxable income.
- Taxpayers can deduct contributions to a Traditional IRA, subject to income limits.

Choosing the Best Strategy for Your Business

Do you go for tax credits or tax deductions? It depends on your situation. A CPA can review your situation and advise on how to get the most tax savings. For example, refundable credits give you more immediate cash, while the Qualified Business Income Deduction can be a big deal for small business owners.

Contact CPA Nerds for Expert Tax Advice

Tax credits and deductions can be complicated but it’s worth it to minimize your tax liability and keep more money in your business. Got questions or want to talk about tax strategy? Reach out to CPA Nerds. Our team of tax pros will help you navigate these opportunities and get the most out of every dollar.