Topic 05 · 5 min read
Credits versus Deductions
A deduction shaves income; a credit pays the bill.
A deduction reduces the income being taxed, so its value depends on your tax bracket. A credit reduces the tax itself, dollar for dollar, so a $1,000 credit is worth $1,000 to everyone who qualifies. Credits are the stronger tool whenever both are available.
What to know
- Deduction value equals bracket
- A $1,000 deduction saves $120 in a 12% bracket and $320 in a 32% bracket.
- Nonrefundable credits
- These can take the tax bill down to zero but no further. Extra credit is simply lost, or sometimes carried to a later year.
- Refundable credits
- These can push the bill below zero, producing a refund larger than anything withheld.
- Order of operations
- Deductions apply first to compute tax, then nonrefundable credits, then refundable ones.
- Phase-outs
- Most credits shrink as income climbs past a threshold, which is why lowering AGI can be worth more than it first appears.
The tax benefit
Understanding the difference tells you which planning moves actually move the number at the bottom of the return.
Worked example
Same $2,000, different results
A filer in the 22% bracket with a $2,000 deduction saves $440. The same filer with a $2,000 credit saves $2,000.
Watch out for
- A nonrefundable credit is worthless if the tax bill is already zero.
- Many credits require specific forms and documentation to claim.
- Claiming a credit you do not qualify for can bar you from claiming it for years.
Terms from this topic
Tax creditNonrefundable creditRefundable creditMarginal bracket
0 of 10 topics done in this installment.