Tax credit vs. deduction: Which is better?

Saving money by shrinking your tax bill feels great, and it all starts with knowing how to use tax deductions and tax credits to your advantage.

Before you file your return, make sure you understand how each one works and why they both reduce your tax burden — just in different ways.

A tax credit directly reduces the taxes you owe the Internal Revenue Service (IRS) by providing a dollar-for-dollar reduction of your actual tax bill. For example, if you owed $2,500 on your tax return but are claiming tax credits of $1,500, your taxes due would come down to $1,000.

Because they are direct credits against your tax bill, tax credits greatly reduce your taxes for a given tax year and help you pay less tax overall. An example of a tax credit is the Earned Income Tax Credit, which is a popular refundable tax credit for low- to middle-income Americans.

Read more: What is the earned income tax credit, and do you qualify?

One key thing to understand is the difference between a refundable credit and a nonrefundable credit. Refundable tax credits reduce your tax liability past zero and can result in a refund. Nonrefundable tax credits can take your tax bill to zero, but won’t generate a refund.

For example, if you have a $1,000 tax bill and claim a $1,200 refundable tax credit, the IRS issues you a refund of $200. If the tax credit is nonrefundable, your tax bill would be $0, but you won’t receive a tax refund.

Some tax credits are partially refundable, meaning a portion of the tax credit, up to a dollar cap, is eligible for a refund.

The IRS has specific qualifications and terms that tax credit recipients must meet. These qualifications are related to income, tax filing status, and more.

Each tax credit has its own eligibility rules. Common ones include:

• Low to moderate income

• Small business owners

• Parents and caregivers

• Paying for higher education

• Saving for retirement

• Investing in home energy improvements and renovations

• Purchasing health insurance from the marketplace

Some less common situations that could qualify for tax credits include paying taxes overseas or overpaying Social Security taxes.

Tax credits fall into several categories, but here’s a snapshot of the most popular ones that may apply to your personal finances.

Family and dependent credits

Two of the most frequently used tax credits are the child tax credit and the earned income tax credit (EITC). The child tax credit lightens your tax load for having a dependent under your care in the United States, and the earned income tax credit is for taxpayers who fall below the poverty line according to filing status. Child and dependent care credits, education credits, and adoption credits also fall into this category.

There are two education credits you might be able to claim on your taxes. One is the American Opportunity Tax Credit (AOTC), a refundable tax credit of up to $2,500 per student for educational expenses. To be eligible, you must meet the following qualifications:

• Pursuing a degree at an accredited institution

• Attending at least part time during the tax year

• Not claimed as a dependent on anyone else’s taxes

• Have a modified adjusted gross income of $80,000 or less

The other education credit, called the Lifetime Learning Credit, has similar requirements and income limits but is nonrefundable and capped at $2,000 per tax return. This tax credit covers tuition costs for any post-secondary education or courses that help to acquire or improve job skills.

You can claim both credits on the same tax return, but not for the same educational expenses.

Income and savings credits

Several types of tax credits fall under this umbrella, but the most frequently used is the retirement savings contribution credit — commonly known as the saver’s credit — which credits you for contributions made to your individual retirement account. It’s limited to middle- and low-income earners.

Read more: What is the saver’s credit?

Tax credits available for homeowners include residential energy credits, home energy tax credits, and credits for energy-efficient home improvements.

Qualifying expenses are detailed at Energy.gov but could include up to 30% reimbursement or $1,200 toward the cost of exterior doors and windows, insulation, air conditioners, water heaters, furnaces, boilers, heat pumps, and high-efficiency wood or biomass stoves.

But the window of opportunity to claim these credits is almost closed. The Energy Efficient Home Improvement Credit and the Residential Clean Energy Credit were supposed to run through 2032 and 2034. But the One Big Beautiful Bill Act, passed earlier this year, fast-tracked their sunset date to Dec. 31, 2025.

You can still claim the credits when filing your 2025 taxes, but the product must be paid for and placed in service before Dec. 31.

The IRS offers a Premium Tax Credit (PTC), which helps eligible individuals and families cover health insurance premiums purchased through the federal healthcare marketplace. This tax credit is typically offered to moderate- and low-income families who are not eligible to receive coverage through an employer-sponsored plan.

Instead of taking money off your tax bill, tax deductions reduce your taxable income. How much a tax deduction lowers your tax liability depends on your tax bracket.

Tax deductions can work both as above-the-line deductions or as itemized deductions. Above-the-line deductions are applied to your adjusted gross income (AGI) even if you claim the standard deduction on your income tax return. Itemized deductions can only be used in place of the standard deduction in calculating the taxes you owe.

Learn more: What is taxable income?

One of the biggest decisions taxpayers make is whether to itemize deductions or take the standard deduction. The standard deduction reduces what you owe by subtracting a flat dollar amount from your taxable income based on your filing status

Above-the-line deductions reduce your taxable income and are part of determining your adjusted gross income (AGI).

Here are common above-the-line deductions you may be able to take:

• Student loan interest

• Retirement (IRA) contributions

• Health savings account (HSA) contributions

• Unreimbursed business expenses

• Education or teaching expenses

• Alimony (if divorce decree is 2018 or earlier)

If you are self-employed or run your own business, you may be eligible for small business tax deductions including home office deductions and reimbursement for travel expenses, office supplies, and more.

Itemized tax deductions, sometimes referred to as below-the-line deductions, can be claimed instead of taking the standard deduction. The key is to ensure that the sum total of your itemized deductions exceeds the standard deduction so you reduce your overall tax liability.

Here are common ways taxpayers itemize deductions to minimize their tax burden:

• Capital losses

• Charitable donations

• Gambling losses and debt

• Home mortgage interest

• State and local income, sales, and property taxes

• Losses from a federally declared disaster or theft

• Medical and dental expenses that exceed 7.5% of AGI

Consult the IRS list of itemized and deductible expenses, as certain rules may apply for what can be claimed as an expense and what documentation you’ll need to include with your tax forms.

Above-the-line deductions reduce your taxable income and are part of determining your adjusted gross income (AGI).

Here are common above-the-line deductions you may be able to take:

• Student loan interest

• Retirement (IRA) contributions

• Health savings account (HSA) contributions

• Unreimbursed business expenses

• Education or teaching expenses

• Alimony (if divorce decree is 2018 or earlier)

If you own a small business, you may be eligible for other tax deductions, including home office deductions and reimbursement for travel expenses, office supplies, and more.

Itemized tax deductions, sometimes referred to as below-the-line deductions, can be claimed instead of taking the standard deduction. The key is to ensure that the sum total of your itemized deductions exceeds the standard deduction so you reduce your overall tax liability.

Here are common ways taxpayers itemize deductions to minimize their tax burden:

• Capital losses

• Donations to charity

• Gambling losses and debt

• Home mortgage interest

• State and local income, sales, and property taxes

• Losses from a federally declared disaster or theft

• Medical and dental expenses that exceed 7.5% of AGI

Consult the IRS list of itemized and deductible expenses because certain rules may apply regarding what can be claimed as an expense and the documentation you’ll need to include with your tax forms.

Learn more: Standard deduction vs. itemized deduction: How to decide which tax filing approach is right

You don’t need to be a tax professional to see how tax credits and deductions might work together for the average taxpayer.

Let’s say your income is around $100,000, and you’re married filing jointly. That puts you in the 12% tax bracket. Before deductions and credits, your tax payment would be about $8,000.

If you decide to itemize your taxes through a combination of deductions for mortgage interest and charitable contributions, you could reduce your taxable income to $90,000. Your taxes owed would fall by about $1,000.

You also have two kids, so you receive a $4,000 child tax credit, reducing your tax bill to about $3,000.

The good news is that because of how tax preparation works, you don’t necessarily have to choose. While you can’t apply a tax credit and a tax deduction for the same expenses, you can use specific deductions and tax credits to reduce the amount of tax you owe and maximize your deduction amount.

While tax credits are more effective because they apply a dollar-for-dollar credit to the taxes you owe, credits and deductions can work together to reduce your taxable income and lower your marginal tax bracket, which translates into a less expensive tax season for everyone.