Tax Credit vs Deduction: What’s the Difference?

Taxes are simple in concept. A portion of the money you earn will be paid to the government for essential services, including the upkeep and construction of roads and bridges, the defense of the nation, investments in education or work programs, and social welfare. However, what you owe and calculating your taxes can be pretty complicated. There are payroll taxes that you and your employer both pay. The portion of your paycheck dedicated towards income taxes is separate from the money for Medicare and Social Security. Then there are indirect taxes on imported goods or certain services and taxes paid on property, investment income, or foreign assets. 

Your tax liability depends mainly on what you earn and what you owe. But many factors can alter that tax liability. If you make a high income but don’t own any properties, you may pay fewer taxes than someone with a more modest income but multiple properties. Given certain circumstances, you may be eligible for tax credits, which is money the government gives you to pay for some of your tax liabilities. Multiple dependents entitle you to a more significant tax break than a bachelor without children, for example. Larger cars with more hefty emissions might command more significant vehicle taxes than a small hybrid. 

Then, there are deductions. The standard deduction is available as an option for every taxpayer. Taxpayers who might stand to benefit more from going into detail with itemized deductions can opt out of a standard deduction and itemize instead. Your tax credits and your tax deductions are two of the most common ways to reduce your tax liability each year, come Tax Day. Both are applied for through your tax return. Understanding the difference – and knowing which applies to you – can help you save more money and avoid the unwanted scrutiny of the IRS. 

What Is a Tax Credit?

The IRS is not just in the business of collecting taxpayer money – it can also give money back under certain circumstances. The IRS will “pay” you through tax credits or tax refunds. The difference between the two is simple: a tax credit is money the IRS adds to your tax account to be deducted from your current taxes. This means that your tax credits are the first to go after all is said and done and the amount of money you owe the government has been established. They can help reduce what you owe the government at the end of the day, leading to a greater tax refund. 

If the money you send the IRS with every paycheck through withholding (or through voluntary quarterly/monthly tax payments) amounts to more than you end up owing, the IRS will issue a tax refund, giving you money back. A tax refund is money the IRS gives you to cover overpayment. Your tax payments are based on an estimate determined through your last tax year. Your tax credits can lead to a tax refund because they further reduce what you owe the IRS. This means your account with the IRS goes further into the black, and they owe you a bigger refund. 

Tax credits also act as a cushion against unexpected tax costs. If you made a mistake on your return, for example, or forgot to report certain income, it may be that you owe more than you expected to, and the money you withheld through your paychecks or sent in every month doesn’t cut it. At this point, any tax credits you claim and qualify for can help reduce that tax debt and even turn it back around into a modest refund. Tax credits are generally applied to alleviate pressure on individual taxpayers who might be more susceptible to financial struggle.

For example, the Earned Income Tax Credit is a standard tax credit for which low- and moderate-income taxpayers can apply. It helps further reduce the tax burden on poorer families. The amount of tax credit awarded to each qualifying taxpayer depends on their income and the number of dependents. Similarly, many taxpayers are also eligible for the Child Tax Credit. As the name implies, this tax credit cuts your tax liability based on the number of qualifying children you care for. These are just two common examples. There are a few others

What Is a Tax Deduction?

Unlike a tax credit, every American taxpayer is eligible for a tax deduction. However, individual taxpayers must choose between the standard default and the more nuanced itemized deductions. A tax deduction lowers your taxable income for the year. The way it works is this – the IRS determines what you owe based on your adjustable gross income, subtracting all applicable deductions from said income. Standard deductions are a flat amount, the same for every taxpayer. Itemized deductions allow you to go into details, deducting from your taxes based on things like:

  • Donations to charity.
  • Unreimbursed business expenses.
  • Contributions to a retirement account.
  • Qualifying medical expenses.
  • Tuition and school fees.
  • And more. 

How Are They Similar?

Both tax credits and tax deductions ultimately reduce what you owe in taxes. While tax deductions reduce your taxable income, tax credits are applied to the final tax bill you owe each year. Keeping track of your deductions and income is essential, especially over time. As your children grow older, you may lose your tax credits related to childrearing. Similarly, while a standard deduction would have made more sense for you last year, perhaps you’re better off going for an itemized deduction given all the changes you’ve gone through this year – especially if you had to change jobs, move around a lot due to work, shoulder multiple business-related travel costs, or struggled with certain medical expenses.

Beware of Too Many Itemized Deductions

Itemized deductions may or may not make the most sense for you, but if they do, you need to be both confident in your math and prepared to defend your decision. Keep any applicable receipts and documents related to your expenses and deductions for at least the last three years. Itemized deductions are more likely to trigger the IRS’s interest and lead to an audit into your financial status, requiring you to back up your claims. 

What If I Made a Mistake on My Taxes? 

We’re only human, and we all make mistakes. If you mess up your taxes, the IRS won’t launch a crusade against you. In most cases, the IRS will automatically rectify inevitable errors and send you a corrected tax bill, even if you forget to report income or took one too many deductions. If more information is needed, the IRS will let you know via mail and ask you for certain supporting documents to prove your claims. A professional tax preparation service and the help of a qualified tax professional can avoid any awkward moments with the IRS by keeping your records safe and organized and creating a straightforward tax plan that minimizes IRS scrutiny.