Tax Credit vs. Tax Deduction: Which Is Better?

Trying to figure out how to maximize your tax refund? Understanding tax credits and tax deductions can help you optimize your tax return and cut your overall tax liability.

Tax credits cut your tax bill dollar for dollar by the amount of the credit. Tax deductions lower your taxable income which may reduce your overall tax liability. 

While tax deductions are less impactful than tax credits, you may be able to claim both on your tax return.

What Is A Tax Credit?

When you are eligible for a tax credit, you subtract the amount of the credit from the overall federal income tax that you have to pay. This dollar-for-dollar reduction has the power to dramatically reduce your overall tax liability. 

Nonrefundable tax credits can take your total tax liability to $0. Refundable tax credits (like the Child Tax Credit or the Earned Income Tax Credit) entitle filers to a refund, even if they have $0 in tax liability. 

For example, a married couple earning $120,000 with two children under the age of 17 can claim a $2,000 tax credit for each child. The Child Tax Credit will reduce their tax liability by $4,000.

Some popular tax credits include: 

• The Saver’s Credit you can claim if you meet income requirements and you contribute to an eligible retirement account. 
• The American Opportunity Tax Credit allows you to claim a tax credit for higher education expenses when you or a dependent attends school. You can only claim the AOTC for four years. 
• The Lifetime Learning Credit allows you to claim a credit for higher education expenses beyond the first four years. 
• If you pay for daycare or other forms of care for a dependent, look into the Child and Dependent Care Credit.

What Is A Tax Deduction?

Tax deductions lower your taxable income which reduces your tax liability. This is the amount of the deduction multiplied by your marginal tax rate. 

For example, a married couple (filing jointly) that earns $120,000 combined has a marginal tax rate of 22%. If this couple contributes $10,000 to a 401(k), they will have a $10,000 tax deduction. Given their marginal tax rate, they will reduce their tax liability by 22% of $10,000 or $2,200. 

Some of the most important tax deductions include: 

• Business expenses associated with your side hustle.
• Pre-tax contributions to retirement accounts, such as 401(k) or IRA contributions.
• Itemized deductions such as to property taxes, charitable contributions, and medical expenses.

What Is Better: A Tax Credit Or A Tax Deduction?

Tax credits reduce your tax liability by the dollar, based on the credit amount you receive while tax deductions only cut your taxable income. 

Consider a single person who earns $50,000 and spends $2,500 on higher education expenses and contributes $2,500 to their 401(k).

Here is how it breaks down:

• This taxpayer is eligible for the American Opportunity Tax Credit, which cuts her tax bill by $2,500. 
• She is also eligible for a $2,500 tax deduction because of their 401(k) contributions. 
• Given her 22% marginal tax rate, the $2,500 contribution to the 401(k) only cuts her tax bill by $550.

Tax credits are more powerful than tax deductions but you rarely have to choose between the two. Take advantage of as many credits and deductions you qualify for to keep your tax liability low.

Do I Need To Know Whether To Claim A Tax Credit Or A Deduction?

Unless you’re filing your taxes by hand, you don’t need to know which credits or deductions to claim. 

The best tax software (including free tax software) can optimize your tax return, so you get the maximum refund based on your situation. 

Your eligibility for credits and deductions often depends on multiple factors including your income and other credits or deductions you claim. 

The software can optimize these factors on your behalf.