Tax season is around the corner — a time full of forms, rules, and terminology. Among the many terms you’ll encounter, two of the most common are “tax credit” and “tax deduction.” Both can lower the amount of taxes you owe, but they work in different ways and can have varying impacts on your tax returns.

Here, we break down the distinctions between the two, so you can craft a smart tax strategy that maximizes your savings and supports your financial goals.

What Is a Tax Credit?

A tax credit is a dollar-for-dollar reduction in your tax liability. In simple terms, if you owe $5,000 in taxes and qualify for a $1,000 tax credit, your tax bill is reduced directly to $4,000. Tax credits can be refundable or nonrefundable:

Refundable Tax Credits: If the credit reduces your tax liability to below zero, you may receive the remaining amount as a refund. For example, if your tax liability is $500 and you have a $1,000 refundable tax credit, you’ll receive a $500 refund.

Nonrefundable Tax Credits: These can reduce your tax liability to zero, but any excess credit beyond your tax liability is forfeited. For instance, if your tax liability is $500 and you have a $1,000 nonrefundable tax credit, you won’t owe taxes, but you also won’t receive the $500 difference as a refund.

Common credits include the Child Tax Credit, Earned Income Tax Credit (EITC), and education credits like the American Opportunity Credit and Lifetime Learning Credit.

What Is a Tax Deduction?

A tax deduction reduces your taxable income, which in turn lowers the amount of taxes you owe. Unlike a tax credit, which directly lowers your tax bill, a deduction works by decreasing the portion of your income subject to taxes.

For example, if you earn $50,000 and qualify for a $5,000 deduction, your taxable income is reduced to $45,000. The actual tax savings depend on your tax bracket. If you’re in the 22% tax bracket, a $5,000 deduction would save you $1,100 in taxes (22% of $5,000).

Common types of deductions include the standard deduction, mortgage interest deduction, and charitable contributions.

Which Is Better?

The answer ultimately depends on your individual tax situation, but credits are generally more impactful than tax deductions because they directly reduce the amount of tax you owe. Here’s a closer look at how they compare:

Impact on Taxes Owed: Tax credits are often more impactful than deductions because they directly reduce your tax bill dollar-for-dollar.

Refundability: Refundable credits can provide additional financial benefits since they allow you to receive a refund if the credit exceeds your tax liability.

Eligibility: Tax credits often come with specific qualifications, such as income limits or dependent requirements, which can make them harder to claim. Deductions, like the standard deduction, are generally easier to claim and are available to most taxpayers.

Example: Tax Credit vs Tax Deduction in Action

Let’s say you’re a single filer with $150,000 in taxable income and owe $30,000 in taxes. Here’s how a $5,000 tax credit and a $5,000 tax deduction would affect your tax liability:

Tax Credit: A $5,000 credit reduces your tax bill directly from $30,000 to $25,000.

Tax Deduction: A $5,000 tax deduction reduces your taxable income to $145,000. If you’re in the 24% tax bracket, this saves you $1,200 in taxes, lowering your bill to $28,800.

In this scenario, the tax credit provides significantly more savings than the tax deduction.

How to Maximize Your Tax Savings

While credits often provide greater savings, deductions shouldn’t be overlooked. For example, itemizing your deductions might allow you to claim more expenses than the standard deduction, potentially lowering your taxable income further. Pairing deductions with available tax credits can maximize your overall tax savings.

If you’re unsure how to navigate these options or just want to ensure you’re not leaving money on the table, consider working with a tax professional. Tax credits and deductions operate differently and have unique advantages, and an advisor can help ensure you’re making the most of your options. Ready to get started? Schedule a consultation with an Ironwood Wealth Management expert and take control of your tax strategy today.