While paying taxes is a reality, the IRS offers taxpayers the opportunity to reduce what they owe through various tax deductions and tax credits. But it’s not as simple as it seems. Before you can benefit from each deduction or credit, you must meet specific criteria. And while deductions and credits can reduce taxes, how they affect your overall tax bill and eventual tax refund can be very different.

Here’s what you need to know about the differences between tax deductions and tax credits and how they can help you reduce your tax bill and maximize your tax refund.

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Tax deduction or tax credit: what it means for your tax refund

The main difference between a tax credit and a tax deduction is that a credit reduces the amount of tax you owe and a deduction reduces your taxable income.

How a tax credit affects your refund

The value of a tax credit is easy to measure since each dollar of credit reduces your tax liability by one dollar. For example, if your tax liability for the year is $10,000 but you receive a $2,000 tax credit, your tax liability drops to $8,000. If your liability was $2,000, the $2,000 credit would reduce it to $0.

What this means for your refund depends on how much tax you paid during the tax year. If you had paid the entire $10,000 tax liability through withholding tax from your paycheck, you would have received a $2,000 refund. If, on the other hand, you had only withheld $8,000, you would not owe any additional tax, but you would not get a refund because you would have paid the amount due after applying the credit.

How a tax deduction affects your refund

The impact of a tax deduction on your refund depends on your tax bracket, because a tax deduction only reduces your taxable income.

Tax brackets are the seven income levels to which a particular tax rate applies. For 2024, the tax brackets are:

Your tax bracket is the one that applies to the last dollar you earned. So, if you had an income of $40,000, you would be in the 12% tax bracket: your first $11,000 would be taxed at 10% and your income from $11,001 to $40,000 would be taxed at 12%. .

The tax rate on your last dollar earned — 12% in this example — is your marginal tax rate. The higher your marginal tax rate, the greater your potential refund.

To find out how much a deduction saves you, multiply your marginal tax rate by the amount of the deduction. For example, if you can deduct $7,000 for contributions you made to a traditional IRA and you fall in the 12% tax bracket, multiply $7,000 by 0.12 to find that the deduction allows you to save $840 on your taxes. If you were in the 32% tax bracket that year, that same $7,000 deduction would save you $2,240.

Learn more: 10 tax loopholes that could save you thousands of dollars

What are tax deductions?

Tax deductions are radiation that you use to reduce your taxable income before calculating the amount of tax you owe. For example, if you earn $55,000, but qualify for a $1,000 tax deduction, your taxable income drops to $54,000..

Deductions allowed by the IRS include adjustments to income and a choice between the standard deduction and itemized deductions.

Income adjustments

You can claim income adjustments – sometimes called “above the line” deductions – whether you claim the standard deduction or itemize your deductions. Income adjustments include:

Standard deduction and itemized deductions

The standard deduction makes filing your taxes easier because it’s a flat amount – $14,600 for individual filers ($29,200 for married joint filers) – no worksheets, calendars or calculations needed from you. But some taxpayers get a bigger benefit by itemizing deductions.

Itemized deductions are individual expenses that the IRS allows you to deduct from your taxable income. Some of the most common are:

• Charitable donations

• Gambling lossesup to the amount of your winnings

• Medical expenses that exceed 7.5% of your adjusted gross income

• Mortgage interest

• Property tax, within certain limits

Each year, you must decide whether you want to itemize your deductions or take the standard deduction.

Learn more: Tax deductions you don’t know about

What is a tax credit?

A tax credit is an amount that is directly subtracted from the amount of tax you owe. For example, if you owe $4,000 in taxes and qualify for a $1,000 tax credit, you will only owe $3,000 in taxes.

Tax credits are divided into three categories: refundable credits, partially refundable credits and non-refundable credits.

Repayable credits

Refundable credits allow for a full refund if the credit reduces your tax liability to less than $0. For example, let’s say your total tax liability for the year is $1,500. If you benefit from a refundable tax credit of $2,000, you will get a refund of $500. If your tax liability is $0, you will receive the full $2,000 as a refund.

Here are examples of refundable tax credits:

Partially refundable credits

A partially refundable credit allows part of the credit to reduce your tax liability to less than $0 so that it can be refunded to you even if you owe no tax. THE child tax credit is a good example. Although there are technically two credits, one refundable and one non-refundable, the IRS considers it a partially refundable credit.

The non-refundable child tax credit amounts to $2,000 per eligible child in 2024. If you can’t claim the full amount, you can claim the “additional child tax credit” and get reimbursed up to to $1,700 of your $2,000 credit.

So, if you qualify for the $2,000 child tax credit and your tax liability is $4,000, the credit will reduce your tax liability to $2,000. If your tax liability is $0, the additional child tax credit kicks in to reduce your taxable income to -$1,700, thereby repaying all but $300 of the child tax credit.

Non-refundable credits

Non-refundable credits can only be used to reduce your income tax to $0. Once your total taxes for the year reach $0, non-refundable credits can no longer increase your refund. So if you owe $4,000 in taxes but have $5,000 in credits, the credits reduce your tax liability to $0.

The most popular non-refundable tax credits include:

• Child and dependent care credit

• Lifetime Learning Credit

• Credit for other dependents

• Saving credit

• Energy Efficiency Improvement Credit

Who benefits most from tax credits and tax deductions?

Tax credits benefit low- and middle-income taxpayers the most. This is because many credits have income limits, and lower income means less tax liability or no tax liability. Refundable and partially refundable credits, such as the earned income and child tax credits, help reimburse these taxpayers even if they did not pay or overpaid taxes.

Tax deductions, on the other hand, benefit higher-income taxpayers by reducing taxable income. If deductions reduce taxable income enough, they could move the taxpayer into a lower tax bracket. In this case, the taxpayer realizes additional savings by paying a lower tax rate on their already reduced taxable income.

Upcoming tax changes to watch out for

Every year, the IRS makes changes that can affect your tax liability. Here are some of the changes announced so far by the IRS for 2025:

• The standard deduction will increase from $400 to $800, depending on the status of your filing.

• The tax brackets remain the same, but marginal tax rates within each bracket apply to higher incomes, which could lower taxes for some taxpayers and prevent others from landing in lower brackets. higher taxes.

• The earned income tax credit increases by $216.

• Exemptions for the alternative minimum tax increase, which helps more taxpayers avoid it.

Strategies to Maximize Your Tax Credits and Deductions

Taxes are unavoidable for most Americans, but you can ease their burden by taking steps to maximize credits and deductions.

• Research tax deductions and credits so you know what you’re entitled to. The IRS website, located hereis a great resource.

• Keep accurate financial records and organize deductible and credit-eligible expenses by category. At the end of the year, give them the total so you know if you should take the standard deduction or itemize your deductions.

• If you’re married, calculate your tax liability as separate and joint filers to see which is more beneficial.

• Contribute the full amount allowed to your tax-deferred retirement accounts and your flexible or health savings account

• Plan potentially deductible year-end expenses, such as mortgage payments (for mortgage interest), medical expenses, business expenses, and charitable contributions, when they will benefit you the most: at the end of this year or early next year. .

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Daria Uhlig contributed to the reporting of this article.

Last updated: November 4, 2024

This article was originally published on GOBankingRates.com: Tax credits or tax deductions: which will save you more?