Tax Credits vs. Deductions: What's the Difference?

Tax season comes with a lot of new words. Two of the most common are “credit” and “deduction.” They sound alike, and both can lower the amount of tax you pay. But they work in different ways, and knowing the difference can help you understand your return and ask better questions. This guide explains each one in plain language, walks through a simple example, and points you to free, official help.

The short version

• A deduction lowers the amount of income that gets taxed.
• A credit lowers your tax bill itself.

Think of it this way. A deduction trims the starting number. A credit takes money off the final total.

How deductions work

When you file a federal tax return, you start with your income. Then you subtract certain amounts to get your taxable income. Those subtractions are deductions.

Your tax is then figured on that smaller taxable income. So the value of a deduction depends on your tax rate. If your income is taxed at 10 percent, a $1,000 deduction lowers your tax by about $100. If it’s taxed at a higher rate, the same deduction saves a bit more.

Standard deduction vs. itemized deductions

You generally have two choices for deductions:

1. The standard deduction. This is a set amount based on your filing status, such as single, married filing jointly, or head of household. You don’t need to list your expenses. Most filers use it because it’s simple.
2. Itemized deductions. Instead of the standard amount, you list certain expenses allowed by the IRS, such as some medical costs, state and local taxes up to a limit, mortgage interest, and charitable gifts. You keep records to back them up.

Most people choose whichever option is larger. Tax software and free tax help volunteers can compare both for you. The standard deduction amount changes each year, so check irs.gov for the current figure.

How credits work

A tax credit is subtracted directly from the tax you owe. If your tax comes to $1,500 and you have a $500 credit, your tax drops to $1,000. That’s a dollar-for-dollar reduction.

Because of this, a credit usually has a bigger effect than a deduction of the same size.

Refundable vs. nonrefundable credits

Credits come in two main types:

• Nonrefundable credits can lower your tax to zero, but not below. If the credit is larger than your tax, the extra amount goes unused.
• Refundable credits can lower your tax below zero. Any amount left over can be paid to you as part of your refund, even if you owed no tax at all.

Some credits are partly refundable. The IRS explains which type each credit is on its credits and deductions pages.

A simplified example

This is a simplified, made-up example with round numbers. It is meant only to show how the ideas work. It does not reflect current tax rates, amounts, or rules.

Imagine a person whose income, after the standard deduction, is $30,000. To keep the math easy, pretend all of it is taxed at a flat 10 percent. Their tax would be $3,000.

Scenario A: a $1,000 deduction. The deduction lowers taxable income from $30,000 to $29,000. At 10 percent, the tax is $2,900. The deduction saved $100.

Scenario B: a $1,000 nonrefundable credit. Tax starts at $3,000. The credit takes $1,000 off. The tax is now $2,000. The credit saved $1,000.

Scenario C: a $1,000 refundable credit, with a smaller tax bill. Now imagine someone whose tax comes to only $400. A $1,000 refundable credit wipes out the $400 and the remaining $600 can be added to their refund. If the same credit were nonrefundable, the tax would drop to zero and the other $600 would go unused.

Real tax returns use several tax brackets, and many credits have income limits and other rules. But the basic idea holds: deductions shrink the income that’s taxed, and credits shrink the tax itself.

Common credits for families

Several credits are often discussed for working families. Here are a few, described in general terms:

• Earned Income Tax Credit (EITC). A refundable credit for workers with low to moderate income. The amount depends on income, filing status, and number of children.
• Child Tax Credit. A credit for families with children under a certain age. Part of it may be refundable, depending on the year’s rules.
• Child and Dependent Care Credit. A credit tied to costs for care of a child or dependent while you work or look for work.
• Education credits. Credits that may help with certain college tuition and related costs.

Each credit has its own eligibility rules, and those rules and amounts can change from year to year. Check irs.gov for current rules before you file. The IRS also offers online tools to help you see which credits may apply to your situation.

Getting free filing help

You don’t have to figure this out alone. The IRS points to several free options:

• VITA (Volunteer Income Tax Assistance) offers free tax preparation by IRS-certified volunteers for people who meet the program’s guidelines.
• TCE (Tax Counseling for the Elderly) offers free help with a focus on people age 60 and older.
• IRS Free File lets people within the program’s income limit file a federal return online at no cost through partners listed on irs.gov.

Volunteers and tax software can check which deductions and credits may apply to you. For a list of documents to gather, see our tax season checklist for families. Our document checklist tool can also help you stay organized.

A word of caution

Be careful with anyone who promises a specific refund before seeing your documents, or who wants a fee based on the size of your refund. Use official IRS sources to find trusted help. Our guide to spotting benefit scams has more tips.

The bottom line

A deduction lowers the income you’re taxed on, while a credit lowers your tax bill directly. Refundable credits can add to your refund even when you owe nothing, and nonrefundable credits stop at zero. Most people choose the larger of the standard deduction or itemized deductions. Since the rules change, check irs.gov each year, and consider free help through VITA, TCE, or IRS Free File.