One of the most effective ways to lower your income tax bill is to claim tax credits and tax deductions for which you are eligible. Although some expense categories may qualify for both credits and deductions (for example, certain education and dependent care expenses), the two tax-reduction methods are fundamentally different and not interchangeable.
Basically, tax credits lower your tax amount, dollar for dollar; whereas tax deductions reduce your taxable income – and their ultimate value depends on your tax bracket. For example, if you’re in the 25 percent bracket, a $1,000 deduction lowers your tax bill by $250 (25 percent); but a $1,000 credit can lower your tax bill by up to the full $1,000, no matter your tax bracket.
Here’s a more detailed breakdown:
Tax Credits. There are two basic types of tax credits: refundable and non-refundable.
With refundable tax credits, if the amount of income tax you owe is less than the tax credit(s) for which you are eligible, not only do you pay no tax, but you actually get a refund for the difference. So, for example, if you owe $750 in tax but have $1,000 in refundable credits, you will receive a $250 refund.
Among the more common refundable credits are:
Most tax credits are non-refundable, which means they can’t reduce the amount of tax you owe to less than zero (in other words, they can’t generate a refund if the credit amount is greater than taxes owed). Common non-refundable tax credits include those for:
Tax Deductions. There are many different types of tax deductions. For many people, it’s more advantageous to take the standard deduction, which is an amount subtracted from gross income to determine taxable income. Others, who have large medical, state and local taxes, charitable donations and other expenses are better off itemizing deductions.
Among the more common tax deductions are those for:
It’s important to note that you cannot claim a credit and a deduction for the same expense. For example, you may be able to claim work-related tuition as a miscellaneous business expense deduction or as a lifetime learning credit, but not as both.
Eligibility and rules for tax credits and deductions can be extremely complicated and may change from year to year, so refer to the IRS Website for details.