Tax Credits vs Tax Deductions Whats the DifferenceWhen it’s time to file taxes, navigating the world of tax credits and tax deductions can be confusing. They seem similar, yet they work differently. How do you know what to claim? What will save you the most money?

The Basics: What’s the difference between tax credits and tax deductions?

Tax credits reduce your actual tax liability—the amount you owe to the IRS—dollar for dollar, while tax deductions reduce your taxable income—how much taxable income you claim.

With tax credits, $1 in tax credits is worth $1 off what you owe in taxes. With deductions, $1 in deduction can only be worth $0.396, the highest IRS tax rate as of 2014.

Here’s an example: If you made $50,000 last year and deducted $5,000 in mortgage interest payments for the year, you can reduce your taxable income to $45,000 and only pay taxes on that amount. Because you’re in the 15 percent tax bracket, that deduction is worth $750 ($5,000 x 15 percent). If you were in the 35 percent tax bracket, that same $5,000 would be worth $1,750 ($5,000 x 35 percent).

If, on the other hand, you claim a tax credit—the $2,500 American Opportunity Tax Credit, for example—you will owe the IRS $2,500 less, depending on your income. (Some tax credits are reduced once your income passes a certain level.)

Are all tax credits the same?

Some tax credits are refundable, which means that if the credit reduces your tax liability to zero, you may be able to get money back. For example, according to the IRS, if taking the American Opportunity Tax Credit means you will owe nothing in taxes, you can have 40 percent of the remaining credit (up to $1,000) refunded to you.

Tax credits can also reduce or eliminate the Alternative Minimum Tax (AMT), a parallel tax system created to ensure the wealthy pay enough in taxes. Additionally, refundable tax credits may reduce or completely eliminate self-employment taxes.

If you can claim certain tax credits, such as the Foreign Tax Credit, the Prior Year Minimum Tax Credit, or the Adoption Credit, you can then carry them forward to future years. For example, if your tax liability is $9,000 in a given year and you claim an $11,000 Adoption Credit, the $2,000 difference is not refunded to you. Instead, you can claim the $2,000 in another tax year for up to five years going forward.

Unlike deductions, you don’t have to itemize to use tax credits. They come into play after you’ve reported all of your income and deductions on your tax form.

What do you need to know about tax deductions?

You can either itemize your deductions using Schedule A or take the standard deduction. You should only itemize if your total deductions are more than the standard deduction.

Standard deductions for tax year 2014 are as follows:

  • Single: $6,200
  • Head of Household: $9,100
  • Married Filing Jointly or Qualifying Widow/Widower: $12,400
  • Married Filing Separately: $6,200

Unless you own a home and pay a mortgage, are very ill, or have a lot of unreimbursed business expenses, it’s unlikely you’ll be able to use itemized deductions.

Even when you can itemize, your medical expenses must be reduced by 10 percent of your adjusted gross income (AGI), your miscellaneous employee business expenses must be reduced by 2 percent of your AGI, and your charitable contributions are limited to 50 percent of your AGI (or 30 percent for donations to private foundations or fraternal society).

As your income increases, the itemized deductions are further reduced by phaseouts and alternative minimum taxes.

If you find yourself on the cusp, just barely being able to itemize, here’s a trick you can use: If possible, consider bunching your deductions by paying two years’ worth of property taxes, donations, and medical bills in one year and none in alternate years. That way, every other year you will have enough expenses to itemize. In the alternate year, you will get the full benefit of the standard deduction.

Eva Rosenberg, EA is the publisher of TaxMama.com ®, where your tax questions are answered. She is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches terrific courses that might help individuals and small businesses at CPE Link.