Understanding the Difference Between a Tax Credit and a Deduction

When it comes to reducing your tax bill, two key tools at your disposal are tax credits and deductions. While both lower the amount of tax you owe, they work in very different ways. Understanding the difference is essential for maximizing your tax savings. In this guide, we’ll break down how each works and when it might be best to seek professional guidance, especially if you're unsure about which options apply to your situation.

What is a Tax Deduction?

A tax deduction lowers your taxable income, which means you’ll pay tax on a smaller amount of income. While deductions don’t directly reduce the amount of tax you owe, they can lower your overall tax liability by reducing the portion of your income that is taxed.

There are two main types of deductions:

1. Page 1 (Above-the-Line) Deductions: These deductions appear on the first page of your tax return (Form 1040) and are available whether you itemize deductions or not. Page 1 deductions reduce your adjusted gross income (AGI), which is an important number because it determines eligibility for many tax credits and deductions.

   
   

   Common above-the-line deductions include:

   
   

   • Student Loan Interest: You can deduct up to $2,500 in interest paid on student loans.

   • Traditional IRA Contributions: Contributions to a traditional IRA may be deductible up to the annual limit.

   • Self-Employment Deductions: Half of your self-employment taxes are deductible.

     
     

   Page 1 deductions can be used strategically to lower your AGI, which can make you eligible for additional tax benefits.

   
   

2. Itemized Deductions: If your qualifying deductible expenses exceed the standard deduction ($14,600 for single filers and $29,200 for married filers in 2024), you can itemize your deductions. Itemized deductions appear on Schedule A of your tax return and include specific categories of deductible expenses.

   
   

   Common itemized deductions include:

   
   

   • Mortgage Interest: Deductible interest paid on your home mortgage.

   • State and Local Taxes (SALT): You can deduct state income, property, and sales taxes (up to $10,000).

   • Medical Expenses: Qualifying expenses that exceed 7.5% of your AGI may be deductible.

   • Charitable Contributions: Donations to qualified charities, including both cash and goods. You will need a receipt in order to deduct charitable contributions.

     
     

Choosing between the standard deduction and itemizing depends on which approach reduces your taxable income more. For beginners, it’s often easiest to take the standard deduction, but if you have significant medical expenses, mortgage interest, or charitable contributions, itemizing may offer greater tax savings.

At Lindy Parker, CPA, we can help clients decide how to take advantage of above-the-line deductions, and whether to take the standard deduction or itemize. Our goal is to make sure you’re claiming every deduction you qualify for to minimize your tax liability.

What is a Tax Credit?

A tax credit reduces the amount of tax you owe on a dollar-for-dollar basis. For example, if you owe $2,000 in taxes and qualify for a $500 tax credit, your tax liability will drop to $1,500.

There are two types of credits:

1. Nonrefundable Credits: These reduce your tax liability but won’t result in a refund if the credit exceeds what you owe. For instance, if your tax bill is $1,000 and you claim a $1,500 nonrefundable credit, you’ll reduce your bill to $0 but won’t get the extra $500 as a refund.

   
   

2. Refundable Credits: These credits can reduce your tax liability below zero, meaning you’ll receive a refund if the credit exceeds your tax bill. For example, if your tax liability is $1,000 and you qualify for a $1,500 refundable credit, the IRS will issue you a refund for the remaining $500.

   
   

Common Credits include:

• Earned Income Tax Credit (EITC): A refundable credit for low- to moderate-income taxpayers.

• Child Tax Credit: A partially refundable credit for those with qualifying dependents under 18.

• Education Credits: Credits which help offset the cost of higher education.

  
  

Navigating tax credits can be tricky, as each credit has specific eligibility criteria. At Lindy Parker, CPA, we make sure you don’t leave money on the table by identifying all the credits you qualify for and helping you claim them correctly.

Tax Credits vs. Deductions: Which is Better?

While both credits and deductions lower your tax bill, they do so in different ways:

• Deductions reduce the amount of income that’s subject to tax, indirectly lowering your tax liability.

• Credits directly reduce your tax bill and often provide a more significant benefit, especially if they are refundable.

  
  

For example, let’s say you're in the 22% tax bracket:

• A $1,000 deduction will lower your taxable income, saving you $220 in taxes.

• A $1,000 tax credit, on the other hand, will directly reduce your tax liability by the full $1,000.

  
  

Deductions may be used to strategically lower your taxable income to make you eligible for other deductions or credits that you may not have been eligible for before taking the deduction. These can be advanced tax strategies, so be sure to consult Lindy Parker, CPA or your tax professional before using strategies you are unsure about.

If you’re uncertain about which credits and deductions apply to your specific tax situation, consulting with a professional can make a big difference. At Lindy Parker, CPA, we offer personalized tax preparation services to ensure that you get every deduction and credit available to you.

When Should You Seek Professional Help?

While tax software can guide you through basic credits and deductions, more complex tax situations may require professional expertise. Here are some scenarios where it’s helpful to get support:

• You own a business or have side income: Business deductions can be more complicated, and credits may apply based on specific business activities.

• You have multiple income streams: Investments, rental properties, or freelance work can all have unique deductions and credits.

• You want to maximize savings: It can be challenging to decide when to itemize or rely on the standard deduction. A professional can analyze your financial information and recommend the most beneficial strategy.

  
  

At Lindy Parker, CPA, we simplify the tax process by reviewing your entire financial picture and ensuring that you’re taking advantage of all available tax credits and deductions. With our flat-fee pricing structure, you know exactly what to expect—no surprises, just reliable service designed to save you money.

Understanding the difference between tax credits vs deductions is key to lowering your tax liability and keeping more of your hard-earned money. For those who aren’t sure which tax breaks they qualify for, the best approach is to seek professional advice. Lindy Parker, CPA is here to guide you through every step of the tax preparation process, ensuring that you receive the maximum benefit from every deduction and credit available.