When people talk about lowering their taxes, they often use tax deductions and tax credits as if they were the same thing. They aren’t. Understanding the difference can help you make better decisions when preparing your federal income tax return.
A deduction reduces the amount of income that is subject to tax. A credit works differently: it reduces the tax you owe directly. That distinction becomes especially important when you’re comparing different tax-saving opportunities.
Tax Deductions Reduce Taxable Income
A tax deduction reduces your taxable income before your federal income tax is calculated.
For example, suppose your total income is $60,000 and you have $10,000 in eligible deductions. Your taxable income could potentially be reduced to $50,000, depending on your circumstances and which deductions you qualify for.
Some deductions are available to many taxpayers, while others apply only to people in particular situations.
Common deductions include:
- Retirement contributions
- Mortgage interest
- Charitable contributions
- Certain medical expenses
- State and local taxes
- Qualified business expenses
- Self-employment expenses
- Certain education-related expenses
The important thing is not simply finding a deduction that sounds applicable. You have to meet the requirements for claiming it and, when required, have documentation to support it.
Tax Credits Work Differently
A tax credit generally reduces your actual federal tax liability rather than reducing your taxable income.
For example, if your calculated federal tax is $4,000 and you qualify for a $1,000 tax credit, that credit can generally reduce the tax liability to $3,000.
Some tax credits are refundable. These can potentially provide a refund when the credit is larger than the taxpayer’s remaining tax liability. The IRS identifies the Earned Income Tax Credit and Additional Child Tax Credit among refundable credits available to qualifying taxpayers.
The Child Tax Credit
The Child Tax Credit is one of the most important federal tax credits for families with qualifying children.
Eligibility depends on several factors, including the child’s age, relationship to the taxpayer, residency, dependency status, and other requirements. The IRS also has specific requirements concerning Social Security numbers and income limitations.
Because tax rules surrounding children and dependents can be complicated, it’s worth checking the requirements carefully rather than assuming that having a child automatically qualifies you for the full credit.
The Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is another significant federal tax benefit. It is intended primarily for workers with low to moderate earned income.
Eligibility depends on income, filing status, number of qualifying children, investment income, and other requirements. You don’t necessarily have to have children to qualify, although the rules are different depending on your circumstances.
For eligible taxpayers, the EITC can be particularly valuable because it is refundable.
Education Tax Credits
If you or a family member is attending college or another eligible educational institution, you may be able to claim an education tax credit.
Two of the major federal education credits are the American Opportunity Tax Credit and the Lifetime Learning Credit.
Which one applies depends on factors such as enrollment, qualified education expenses, the student’s situation, and household income.
Business and Self-Employment Deductions
Tax deductions become especially important for self-employed individuals and small-business owners.
Business expenses that are ordinary and necessary for operating a business may be deductible when they meet IRS requirements.
Depending on the business, expenses may include advertising, supplies, software, professional services, business insurance, equipment, and other operating costs.
Good recordkeeping is essential. Receipts, invoices, mileage records, bank statements, and other documentation can make a significant difference if the IRS ever questions a deduction.
Standard Deduction or Itemizing?
One of the biggest decisions when preparing a federal tax return is whether to use the standard deduction or itemize deductions.
The standard deduction is straightforward and works well for many taxpayers. Itemizing can make sense when qualifying deductible expenses are high enough to produce a larger deduction.
There isn’t a universal answer. The better option depends on your income, filing status, expenses, and individual circumstances.
Don’t Overlook Smaller Tax Benefits
Taxpayers often focus on the most obvious deductions and credits while overlooking other benefits they may qualify for.
Before filing, it’s worth reviewing your entire financial situation, including:
- Retirement contributions
- Dependents
- Education expenses
- Childcare expenses
- Charitable donations
- Mortgage interest
- Medical expenses
- Business expenses
- Self-employment income
- Energy-related improvements
- Available refundable tax credits
The goal isn’t to claim every deduction or credit you can find online. The goal is to claim every tax benefit you’re legitimately entitled to while maintaining the records necessary to support your return.
Good Tax Planning Starts Before Tax Season
The best time to think about deductions and credits isn’t necessarily the night before your tax return is due.
Keeping organized records throughout the year makes tax preparation easier and can help you identify opportunities that might otherwise be missed. For business owners and self-employed taxpayers in particular, maintaining accurate records throughout the year can save considerable time when tax season arrives.
Tax laws also change from year to year, so information from an older tax return should not automatically be applied to a new tax year.