When preparing taxes, looking for opportunities to become more tax-efficient and lower your tax bill is natural. In fact, it can be a key part of your overall financial strategy, and one you can implement well before retirement.
Tax credits and deductions are two ways you can reduce your tax burden.
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What is a tax credit?
A tax credit reduces the amount of tax you owe, and it may increase your tax refund. Credits let you deduct from the taxes you owe on a dollar-by-dollar basis. For example, if you receive a $1,000 tax credit, you can directly subtract that amount from the taxes you owe—potentially adding dollars back into your pocket for other purposes, like
What is a tax deduction?
A tax deduction can also lower your tax bill but in a different way. While a tax credit directly reduces the amount of taxes you owe, a tax deduction reduces your taxable income. The benefit of the deduction typically depends on your tax bracket. For example, a deduction may lower your marginal tax rate, which can help reduce the taxes paid on what you've earned.
How can you be tax-efficient year-round?
Comparing tax credits vs. tax deductions
As you start thinking about creating
Impact on taxable income
Because tax credits are applied to your final tax bill, they don't impact your taxable income. Tax deductions, ont he other hand, can help lower your taxable income, which is what the Internal Revenue Service (IRS) uses to determine your tax liability.
Dollar value differences
Tax credits are applied on a dollar-to-dollar basis. For example, $1,000 in credits reduces your tax bill by $1,000 and can potentially provide a refund. That's for everyone across the board, regardless of income.
With tax deductions, the amount can impact taxpayers differently based on their income. Someone who makes $150,000 and qualifies for a $1,000 deduction will experience a much smaller impact on their taxes than someone who makes $47,000 and could be dropped into a lower tax bracket.
Eligibility factors
Tax credits typically have certain eligibility requirements or must meet specific criteria to qualify for them. For example, the
Examples of tax credits & tax deductions
Tax credits can be refundable or nonrefundable, and each has specific eligibility requirements. Refundable credits can be applied to a refund, whereas nonrefundable credits can take your tax bill to zero, but you won't get any money back.
The IRS sets ranges for these credits, which may be based on your income, filing status and dependents.
Some
- Earned income tax credit
- Child tax credit
- Energy tax credits
- Lifetime learning credits
- Adoption credit
For tax deductions, there are two ways to claim these on your taxes. You can choose the standard deduction, which is a fixed amount you can deduct from your income based on filing status. You can also choose to itemize your deductions, which are expenses allowed by the IRS you can take, but you must list each individually on a Schedule A.
Some
- Contributions to a pre-tax retirement plan (401[k], 403[b], Traditional IRA)
- Student loan interest deduction
- Charitable contribution deduction
- Mortgage loan interest deductions
- Contributions to a
health savings account - Property and real estate taxes
Are tax credits or deductions better?
Tax credits are generally considered more favorable than deductions because of their direct impact on your final total tax bill. For many taxpayers, a $2,000 credit can lower your tax bill significantly more than a $2,000 deduction.
| | Tax credit | Tax deduction |
| Reduction method | Reduces taxes owed directly | Lowers taxable income |
| Impact on taxable income | No impact | Decreases taxable income |
| Dollar value | Provides a fixed, dollar-for-dollar reduction on taxes owed | Value varies based on income, deduction amount and tax bracket |
| Eligibility | Generally has specific requirements for qualification | Generally more broad and less restrictive |
| Examples | Earned income tax credit, child tax credit, clean vehicle credit | Mortgage interest deduction, charitable contribution deduction, student loan interest deduction, moving expenses deduction |
Add tax efficiency to your financial strategy
Understanding how tax credits or tax deductions impact your overall tax bill can help you develop a strong,
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