When it comes to filing your annual tax return, understanding the difference between tax deductions and tax credits can be a powerful tool for keeping more of your hard-earned money.

“Tax season can be a daunting time for many individuals, but understanding the ins and outs of tax credits and deductions can make a significant difference in your financial bottom line,” says experienced tax attorney Steve Powell. “These tax-saving tools can help reduce your tax liability, ultimately putting more money back in your pocket.”

Let’s examine the world of tax benefits and break down the key differences between deductions and credits.

Two Avenues to Tax Relief: Deductions and Credits

Deductions and credits essentially serve as discounts that can help reduce the final amount you owe on your tax bill, but they work in slightly different ways.

The Deduction Advantage: Lowering Your Taxable Income

A tax deduction allows you to subtract certain expenses from your total income before calculating your tax bill. Think of it as shrinking the base on which your taxes are applied.

Common deductions include:

• Mortgage Interest: Homeowners can deduct the interest paid on their mortgage (up to the first $750,000 of your mortgage debt for your primary or second home). The IRS says that “in most cases, you can deduct all of your home mortgage interest. How much you can deduct depends on the date of the mortgage, the amount of the mortgage, and how you use the mortgage proceeds.”
  
  
• Charitable Donations: Contributions to qualified charities can be deducted. The IRS says “in general, contributions to charitable organizations may be deducted up to 50 percent of adjusted gross income computed without regard to net operating loss carrybacks.  Contributions to certain private foundations, veterans organizations, fraternal societies, and cemetery organizations are limited to 30 percent adjusted gross income (computed without regard to net operating loss carrybacks), however.
  
  
• State and Local Taxes: In some cases, state and local income taxes or property taxes can be deducted. The IRS says “As an individual, your deduction of state and local income, general sales, and property taxes is limited to a combined total deduction of $10,000 ($5,000 if married filing separately).”
  
  
• Medical Expenses: You may be able to deduct qualified medical expenses that exceed a certain percentage of your adjusted gross income (AGI). IRS clarifies: “If you itemize your deductions … you may be able to deduct the medical and dental expenses you paid for yourself, your spouse, and your dependents during the taxable year to the extent these expenses exceed 7.5 percent of your adjusted gross income for the year. The deduction applies only to expenses not compensated by insurance or otherwise regardless of whether you receive the reimbursement directly or payment is made on your behalf to the doctor, hospital, or other medical provider.”

By claiming deductions, you essentially lower your taxable income, which translates to a potentially lower tax bill.

Let's say your total income is $50,000, and you qualify for deductions totaling $5,000. Your taxable income would then be $45,000, potentially placing you in a lower tax bracket and reducing your overall tax liability.

The Credit Powerhouse: Direct Dollar-for-Dollar Reduction

Tax credits, on the other hand, directly reduce the amount of tax you owe.  Think of it as a straight-up discount on your tax bill.  There are several types of tax credits available, including:

• Child Tax Credit: This credit helps offset the cost of raising children. IRS says “The enhanced credit allowed for qualifying children under age 6 and children under age 18 has expired. For 2023, the initial amount of the CTC is $2,000 for each qualifying child. The credit amount begins to phase out where AGI income exceeds $200,000 ($400,000 in the case of a joint return). The amount of the CTC that can be claimed as a refundable credit is limited as it was in 2020 except that the maximum ACTC amount for each qualifying child increased to $1,500.”
  
  
• Earned Income Tax Credit (EITC): A refundable credit for low- and moderate-income earners. The amount of your credit may change if you have children, dependents, are disabled, or meet other criteria. The IRS says that to qualify for the EITC, you must:
  • Have worked and earned income under $63,398.
  • Have investment income below $11,000 in the tax year 2023.
  • Have a valid Social Security number by the due date of your 2023 return (including extensions).
  • Be a U.S. citizen or a resident alien all year.
  • Not file Form 2555, Foreign Earned Income.
  • Meet certain rules if you are separated from your spouse and not filing a joint tax return.

• Education Credits: Credits are available for qualified education expenses. An education credit helps with the cost of higher education by reducing the amount of tax owed on your tax return. There are two education credits available: the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC).
  
  
• Retirement Savings Credits: Contributions to IRAs or employer-sponsored retirement plans may qualify for credits. Those married filing jointly with AGI more than $73,000 do not qualify ($54,750 head of household; $36,500 for all other filers). For those making less, depending on adjusted gross income reported on your Form 1040 series return, the amount of the credit is 50%, 20%, or 10% of:
  • Contributions you make to a traditional or Roth IRA.
  • Elective salary deferral contributions to a 401(k), 403(b), governmental 457(b), SARSEP, or SIMPLE plan.
  • Voluntary after-tax employee contributions made to a qualified retirement plan (including the federal Thrift Savings Plan) or 403(b) plan.
  • Contributions to a 501(c)(18)(D) plan.
  • Contributions made to an ABLE account for which you are the designated beneficiary (beginning in 2018).

“Unlike deductions, the value of a tax credit is not based on your tax bracket.  A $1,000 credit reduces your tax liability by $1,000, regardless of your income level,” says Powell. “This makes credits generally more valuable than deductions.”

Deductions vs. Credits: Key Differences

Here's a quick breakdown of the key distinctions between deductions and credits:

Bottom line: The key distinction between deductions and credits lies in how they affect your tax liability. Deductions reduce taxable income, while credits reduce the actual amount of tax owed.

Types of Tax Deductions

There are several types of tax deductions, including itemized deductions and standard deductions.

Itemized deductions allow you to deduct specific expenses, such as mortgage interest, state and local taxes, and charitable donations.

Alternatively, taxpayers may choose to take the standard deduction, which is a flat amount determined by the IRS based on filing status.

IRS standard deductions for 2023 (taxes filed in 2024):

• Single: $13,850.
• Married, filing separately: $13,850.
• Married, filing jointly; qualified widow/er: $27,700.
• Head of household: $20,800.

IRS standard deductions for 2024 (taxes filed in 2025):

• Single: $14,600.
• Married, filing separately: $14,600.
• Married, filing jointly; qualified widow/er: $29,200.
• Head of household: $21,900.

Additionally, above-the-line deductions, such as contributions to retirement accounts and student loan interest, reduce adjusted gross income (AGI), while below-the-line deductions, like medical expenses and unreimbursed employee expenses, are itemized deductions that are subtracted from AGI.

Types of Tax Credits

Tax credits come in various forms, including refundable credits and non-refundable credits.

Refundable credits can result in a refund even if the credit exceeds the amount of taxes owed, while non-refundable credits can only reduce tax liability to zero and cannot result in a refund.

Common tax credits for individuals include the Child Tax Credit, which provides a credit for each qualifying child, and the Earned Income Tax Credit, which benefits low-to-moderate-income taxpayers.

Businesses may also be eligible for tax credits, such as the Research and Development Credit and the Work Opportunity Tax Credit, which incentivize specific activities or hiring practices.

Maximizing Tax Benefits

To maximize tax benefits, it's essential to strategize your approach to claiming deductions and credits.

Here are some tips to maximize your tax benefits:

• Stay Organized: Maintain accurate records of your income and expenses throughout the year, as documentation is crucial for claiming deductions and credits.
  
  
• Research Available Credits: The IRS website provides a wealth of information on various tax credits you may qualify for.
  
  
• Consider a Tax Professional: For complex tax situations, consulting with a qualified tax professional can ensure you're claiming all the deductions and credits you deserve.
  
  

Contact the tax pros at Powell Tax Law, who take pride in representing clients who live in Texas and can help represent you in any legal situation involving the IRS, including audits, amended tax returns, and filing a claim in federal court.