We all want to save money on taxes. Who doesn’t? The two best ways to do that are through tax deductions and tax credits.

In a nutshell, tax deductions reduce how much of your income gets taxed (like the standard deduction) and tax credits actually lower your tax bill dollar for dollar.

Let’s say you’re looking at a $1,000 tax deduction and a $1,000 tax credit. If you’re in the 22% tax bracket, a $1,000 tax deduction will lower your taxable income by $1,000, which will cut your tax bill by $220. Sweet deal! But a $1,000 tax credit will actually save you $1,000 in taxes.

They’re both great and both save you money come tax season—they just do it in different ways. Let’s get right into the nitty-gritty details about deductions and credits.
 

What Is a Tax Credit?

A tax credit is pretty straightforward. A credit is a tax incentive that subtracts how much you owe in taxes for the year. If you owe $500 in taxes and you get a $500 credit, then your tax bill magically goes down to zero. Ta-da! 

The more credits you claim, the less money you’ll pay. And depending on the type of credit and how big it is, you could even wind up getting some money back from Uncle Sam (more on that later).  

There are a bunch of credits out there you might qualify for, and they’re usually linked to your income, age or filing status. Here are some of the most common credits taxpayers can claim on their returns:

• Earned income tax credit
• Child tax credit
• American opportunity tax credit
• Lifetime opportunity tax credit
• Retirement savings contributions credit (saver’s credit)
• Foreign tax credit
• Child and dependent care credit
• Adoption credit
• Elderly or disabled credit

While all tax credits lower your tax bill, they don’t all work exactly the same way. The IRS classifies tax credits in two ways: refundable or nonrefundable. What’s the difference? We’re glad you asked!

Refundable vs. Nonrefundable Tax Credits

You can subtract both types of credits from your tax bill. But if a refundable credit is larger than your total tax bill, you get the difference back as a refund. Yes, you can get a refund even if your tax bill is zero. So, if you owe $1,000 in taxes and you have a $1,500 refundable credit, the IRS will send you $500.

With a nonrefundable credit, you won’t get a refund. The best you can hope for is to reduce your tax bill to zero, which is still a really good deal—just don’t expect to get a check in the mail for the difference.
 

What Is a Tax Deduction?

Like we talked about before, a tax deduction lowers how much of your income is taxed. When you hear the word deduction, just think subtraction. You’re simply subtracting how much of your income is taxed and reducing how much you owe to Uncle Sam in the process.

Let’s say your taxable income is $75,000 and you claim $5,000 in tax deductions for charitable donations you gave throughout the year. That means only $70,000 of your income will be taxed! 

Here are some of the most common expenses that are usually tax deductible:

• Charitable donations
• Medical expenses
• State and local taxes
• Student loan interest
• Mortgage interest

As we mentioned before, the first decision you’ll need to make when it’s time to file your taxes is whether to take the standard deduction or itemize your deductions. So, how do you decide? 

Itemizing vs. the Standard Deduction: Which Should I Choose?

Here’s the deal: With the increase in the standard deduction, taking that automatic deduction will make sense for more taxpayers than before. But it’s still important to add up your itemized deductions before you make that decision.

Are your itemized deductions less than the standard deduction? Then simply take the standard deduction and call it a day. But if your itemized deductions are significantly greater, it’s worth going through the extra effort to itemize and lower your taxable income (and your tax bill) in the process. 

If you do decide to itemize your deductions, you’ll probably want to work with a tax professional who can help you claim all the deductions you qualify for and show you how to keep proper records. The last thing you want is to trigger an IRS audit and have the tax man all up in your business.