Tax Deductions vs. Tax Credits

Individual taxpayers can reduce their tax liability, e.g. tax they pay, through both tax deductions and tax credits. These items are both beneficial, however they have different impacts on a taxpayer’s tax return.

Deductions on your tax return are ultimately reductions to your taxable income. Tax deductions on the form 1040 fall under two categories: above the line and below the line. “The line” in these two terms refers to adjusted gross income (AGI). Above the line deductions are taken on the first page above AGI on the 1040 and reduce AGI (AGI equals total income less above the line deductions). Below the line deductions are taken on the second page of the 1040 (below AGI) and they represent subtractions from AGI.

An individual can take the larger of his/her standard deduction ($6,300 for single filers for 2016) or itemized deductions. The greater of the taxpayer’s standard deduction or itemized deductions is subtracted from their AGI. Any applicable exemptions, which are also deductions, are also subtracted from AGI ($4,050 for personal and per dependent for 2016). Taxable income is determined by the following calculation: AGI minus standard or itemized deductions and exemptions. Then, taxable income is multiplied by the individual’s tax rate to calculate how much tax is owed.

Whereas tax deductions reduce the amount of taxable income on an individual’s return, tax credits are a direct reduction in the amount of an individual’s tax liability. Thus, assuming you can take either a credit or deduction for the same amount, the tax credit will have a greater impact on your taxes. The reason for this is that tax credits reduce tax liability by 100% of the amount of the credit.  In contrast, tax deductions reduce tax liability by the amount of the deduction times the individual’s marginal tax rate. Your marginal tax rate is the tax rate you pay on the last dollar of income.

For example, assume a taxpayer filing single earned income of $50,000 in 2016 and therefore falls within the 25% tax bracket. A $1,000 deduction would reduce his/her tax liability by $250 ($1,000 x 25%). However, a $1,000 credit would reduce tax liability by $1,000. The tax credit in this simple example reduces tax paid by $750 more than the deduction would.