Whether you’re tax planning or preparing your income tax return, you’ve probably heard about tax credits and deductions. You also probably know that they’re both good to have when it comes to owing less money to the IRS. Let’s take a closer look at both of these tax benefits, including which one is better, how they work, and how they’re different from each other.
Is a Tax Credit Better Than a Tax Deduction?
Yes, all else being equal, a tax credit is better in that it will save you more in taxes. That being said, in the vast majority of situations, you won’t have to choose between one over the other. In other words, every tax credit and deduction will have its own eligibility requirements, and taking one will usually not result in you being prohibited from taking the other.
Why is a Tax Credit Better Than a Tax Deduction?
The short answer is that a tax credit reduces your tax bill while a tax credit reduces your income subject to taxation. Let’s examine a hypothetical to illustrate.
Let’s say you earn $100,000, have a 35% tax rate, and are eligible for either a $20,000 tax deduction or a $20,000 tax credit, but not both (again, this either/or scenario with tax credits, and deductions don’t usually happen in real life, but imagine you have to pick just one in this example).
You’ll want to take the tax credit and not the deduction because you can reduce your tax bill by $20,000 instead of $7,000.
Here’s how we got these numbers:
| $20,000 Tax Credit | $20,000 Tax Deduction | |
| Your Income | $100,000 | $100,000 |
| Tax Deduction | $0 | $20,000 |
| Taxable Income | $100,000 | $80,000 |
| Preliminary Tax Bill | $35,000 ($100,000 x 35%) | $28,000 ($80,000 x 35%) |
| Tax Credit | $20,000 | $0 |
| Final Tax Bill | $15,000 | $28,000 |
By taking a $20,000 tax credit, you reduced what you owed the IRS by $20,000 ($35,000 – $15,000). In contrast, by taking the $20,000 tax deduction, you reduced what you owed the IRS by only $7,000 ($35,000 – $28,000).
Types of Tax Credits
Most tax credits for individual income tax purposes can be divided into two types. First, you have refundable tax credits, which allow you to pocket any unused tax credits in the form of a tax refund check from the IRS. For instance, if you owe the IRS $5,000 in taxes but can claim a $6,000 tax credit, you not only pay no taxes, but you’ll also get a $1,000 check from the IRS.
Second, you have nonrefundable tax credits. Because these are nonrefundable, any leftover tax credits are lost. Using the prior example, owing the IRS $5,000 and having a $6,000 tax credit means you owe $0 in taxes, with no $1,000 refund check coming your way.
Types of Tax Deductions
Most taxpayers can take either the standard deduction or itemize their deductions. For the 2024 tax year, the standard deduction is $14,600 for individual taxpayers (and married taxpayers filing individually) and $29,200 for married couples filing jointly.
When it comes to tax credits and deductions, the majority of taxpayers don’t have to choose one or the other. But when it comes to itemized or standard deductions, you have to choose one or the other.
In theory, it’s easy to choose, as you’ll take whichever is larger. In practice, it’s not as easy, as you have to add up all your individual deductions and see if that amount is larger than the standard deduction. Typical deductible expenses include things like:
- Home mortgage interest
- Charitable donations
- Certain medical expenses
Many of these deductions have special rules and eligibility requirements, so it’s not always easy to figure out how much each of these deductions are and if you’ll be eligible for them. Then there’s the added burden of keeping proper records to support these deductions in case you get audited by the IRS. As a result, for many taxpayers, taking the standard deduction is the right move. This is because it either results in a larger tax deduction or because it’s not worth the hassle and stress of itemizing the deductions.
Bottom Line
Tax credits are more desirable than tax deductions. Although, in most cases, you don’t have to choose between the two. However, when it comes to deductions for individual income tax purposes, you’ll have to choose either the standard deduction or itemize your deductions.
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