Tax Credits and Tax Deductions

In this topic, you'll learn:

• Learning the difference between credits and deductions.
• Exploring when itemizing deductions may make sense.
• Understanding popular tax credits.

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Tax credits and tax deductions are two common terms used when filing taxes. While they may sound similar, they are two different types of tax benefits that can help you lower your tax bill. Understanding the difference between tax credits and tax deductions is a helpful starting point for making sense of your tax bill and identifying potential savings.

Tax Deductions

Tax deductions reduce your taxable income, ultimately reducing the tax you owe. Deductions are typically expenses incurred during the tax year that the IRS allows you to deduct from your taxable income. For example, if your taxable income is $50,000 and you have a $5,000 tax deduction, your taxable income will be reduced to $45,000.

When filing your taxes, you must choose between taking the standard deduction and itemizing your deductions.

The Standard Deduction

The standard deduction is a fixed dollar amount you can subtract from your income based on your filing status. The standard deduction is a simple way to reduce your taxable income without tracking individual expenses. For many taxpayers, it results in equal or greater savings than itemizing - though this depends on your specific situation.

For the 2025 tax year, the standard deduction amounts are:

• Single filers: $15,750
• Married filing jointly / qualified widow(er): $31,500
• Married filing separately: $15,750
• Head of household: $23,625

It's important to note that choosing the standard deduction doesn't mean that it's the only deduction allowed without itemizing. While limits apply, student loan interest, health savings contributions, and qualified retirement account contributions are all deductible – even if you take the standard deduction.

Itemized Deductions

Itemized deductions are specific expenses that you can deduct from your taxable income but include a much more comprehensive range of expenses when compared with those allowed when taking the standard deduction. Charitable contributions, mortgage interest, significant medical expenses, a portion of state and local taxes, plus more are all deductible when itemizing. 

To itemize deductions, the total amount of your deductions should exceed that of the standard deduction that applies to your filing status. Considering the generous standard deduction amounts, only about 15% of taxpayers currently itemize deductions.

Tax Credits

Tax credits are often more valuable than tax deductions because they reduce the amount of tax you owe on a dollar-for-dollar basis. For example, if you have a $1,000 tax credit, your tax bill will be reduced by $1,000. But suppose you have a $1,000 tax deduction. In that case, your tax bill is reduced by the amount of the deduction multiplied by your tax bracket – so if you're in the 22% tax bracket, the $1,000 deduction would reduce your bill by $220. Quite a difference!

There are two types of tax credits: non-refundable and refundable. Non-refundable tax credits reduce your tax liability to zero, but you won't receive a refund if the credit exceeds the amount of tax you owe. For example, suppose you owe $500 in taxes and have a $1,000 non-refundable tax credit. In that case, your tax liability will be reduced to zero, but you won't receive the extra $500 as a refund.

On the other hand, refundable tax credits can reduce your tax liability to zero, and you may receive the remaining credit amount as a refund. For example, suppose you owe $500 in taxes and have a $1,000 refundable tax credit. In that case, your tax liability will be reduced to zero, and you'll receive the extra $500 as a refund.

Some common tax credits include:

American Opportunity Tax Credit (AOTC)

The AOTC is a credit for higher education expenses that can provide a credit of up to $2,500 per eligible student per year for the first four years of college. To qualify for the AOTC, you must have paid qualified education expenses for yourself, your spouse, or your dependents. However, the credit begins to phase out for higher-income taxpayers, starting at $80,000 of modified adjusted gross income for single filers and $160,000 for joint filers.

The Child and Dependent Care Tax Credit (CDCTC)

The CDCTC is a tax credit designed to help working parents or guardians pay for the care of a child under 13 or a qualifying dependent while they work or look for work. The credit can be applied to expenses related to daycare, summer camp, before and after-school care, and similar services. 

The 35% credit applies to up to $3,000 of expenses for one child or dependent and up to $6,000 for two or more dependents. However, the percentage of allowable expenses decreases for higher-income earners, reducing credit value. Additionally, payments made through tax-advantaged programs such as a dependent-care flexible spending account at work may lower the amount of the credit.

Child Tax Credit (CTC)

The CTC is a tax credit available to eligible taxpayers with a qualifying child. You could receive up to $2,200 per qualifying child, and in some cases, a portion of the credit may be refundable - meaning you could receive money back even if you don't owe taxes. Eligibility rules and credit amounts can change, so check IRS.gov or consult a tax professional for the most current figures.

To be eligible for the credit, the child must be under the age of 17, claimed as a dependent on your tax return, be related to you, live with you for at least half of the year, and be a U.S. citizen, U.S. national, or U.S. resident alien. You must also provide at least half of their financial support. The CTC is phased out for taxpayers with higher incomes.

Earned Income Tax Credit (EITC)

You may be eligible for the EITC if you are a low-to-moderate-income taxpayer. The credit is based on your earned income and the number of qualifying children in your household. The maximum benefit is up to $8,046 in 2025 for families with three or more children. 

The EITC is refundable, which means that if the credit exceeds the tax owed, you will receive a refund for the excess amount. To be eligible for the EITC, you must have earned income during the tax year and meet specific income requirements, which vary depending on your filing status and the number of qualifying children you have.

Lifetime Learning Credit (LLC)

The LLC is another credit for higher education expenses that provides a credit of up to $2,000 per tax return. Unlike the AOTC, the LLC has no limit on how many years it can be claimed and can be used for graduate-level courses or job-skills training. Like the American Opportunity Tax Credit, the credit begins to phase out for higher-income taxpayers, starting at $80,000 of modified adjusted gross income for single filers and $160,000 for joint filers.

Retirement Savings Contributions Credit (Saver's Credit)

The Saver's Credit is a credit for taxpayers contributing to a qualified retirement account, such as an IRA or 401(k). The credit is worth up to $1,000 for individuals and $2,000 for couples filing jointly, based on the amount contributed and income. The full credit goes to couples earning less than $47,500 and single filers earning up to $23,750.  Eligibility is phased out for couples earning $79,000 or more and single filers earning $39,500 or more in 2025.

The Takeaway

Both tax deductions and tax credits can be valuable tools for reducing your tax liability. However, many potential deductions and credits are limited and can be phased out based on your income. When exploring potential tax credits and deductions, it can be helpful to seek the advice of a professional.