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Tax credit vs. tax deduction: What's the difference?

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Steve Widoff

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. Tax credits reduce the amount you owe, while tax deductions lower your taxable income. The two terms are often mistakenly used interchangeably, so learning the difference between a tax credit and a tax deduction can help you be more strategic about your approach.

Thrivent's Retirement Readiness Survey found retirees wish they had paid more attention to how taxes would impact their retirement savings. How you approach your tax bill plays a big role, so here's what you need to know.

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 saving for retirement.

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?

Aligning your financial plans with your goals can help you maximize your tax efficiency throughout the year.
Leverage your accounts & savings plans for tax efficiency

Comparing tax credits vs. tax deductions

As you start thinking about creating income tax strategies for long-term planning, here are some additional distinctions between tax credits and deductions that you should keep in mind:

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 child tax credit is only available to taxpayers who have a qualifying child under the age of 17 as of the end of the year. Deductions are generally more commonly applicable and have fewer restrictions. However, if you decide to itemize deductions, you may need to provide more documentation.

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 common tax credits include:

  • 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 common tax deductions/adjustments include:

  • 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
Generally has specific requirements for qualification
Generally more broad and less restrictive
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, tax-efficient strategy. While both can reduce your tax burden, they have different direct effects on your tax bill.

Consult with a Thrivent financial advisor to help you learn how to maximize your taxes and align your plans with your financial goals. They can provide a personalized approach to ensure your tax strategy matches your long- and short-term plans, helping you save for the future.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.