What Is the Difference Between a Tax Credit & a Tax Deduction?
From a practical perspective, both tax credits and deductions reduce your tax. The difference between credits and tax deductions centers around their process, not their effect. Understanding the Internal Revenue Service's rationale where credits and deductions are concerned can help you to minimize your overall tax liability and thus bring you a bigger refund at tax time.
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Definition
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A tax credit reduces the income tax you pay, while a deduction reduces the amount of your income that is subject to income tax. Examples of credits include the American Opportunity Credit, Hope Credit and Lifetime Learning Credit, while examples of deductions include the tuition and fees deduction, student loan and interest deduction, and deductions of medical expenses to name a few.
How It Works
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Tax deductions are expenses incurred during the year that are allowed to be deducted on your income tax return. Credits, on the other hand, are often federal benefits that encourage certain behaviors. For example, the Earned Income Credit (EIC) encourages taxpayers (especially those with kids) to maintain employment. There is a space allotted on Form 1040 for all deductions and credits that are available. In most cases, Form 1040EZ cannot be used to claim deductions.
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Comparison
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Tax credits are often viewed as being more beneficial than tax deductions of a similar value since credits reduce the tax directly while deductions only reduce the taxable income amount. Reducing the taxable income amount means that the actual reduction isn't as great as the credit allowance and thus, it isn't as valuable as a tax credit.
Considerations
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There are two categories for tax credits; refundable and non-refundable credits. Refundable credits can reduce your tax below zero, while non-refundable credits cannot. What this means in a practical sense is that with refundable credits, you could conceivably have no tax liability and still receive a refund. This is not true of non-refundable credits. The best known and most widely used refundable credit is the Earned Income Credit (EIC).
Warning
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Taxpayers are only allowed to claim those credits and deductions for which they are eligible. The eligibility guidelines for most credits and deductions are found in IRS Publication 17. Taxpayers who overstate their deductions or misstate their credits could be disallowed from claiming future deductions (as is the case with the Earned Income Credit) or forced to pay penalties and interest on the unpaid tax that resulted from the error.
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References
- Photo Credit tax forms image by Chad McDermott from Fotolia.com
