Deductions and credits can reduce what you owe in taxes each year , but they work differently:
- Deductions lower your taxable income by subtracting certain expenses from your total income. This means you pay tax on a smaller amount, so your tax bill is reduced based on your tax rate. For example, if you have $10,000 in deductions and you are in a 12% tax bracket, your tax bill is reduced by $1,200 (12% of $10,000)
- Credits directly reduce the amount of tax you owe dollar for dollar after your tax has been calculated. For instance, a $1,000 tax credit reduces your tax bill by $1,000. Credits are generally more valuable than deductions because they reduce tax liability directly. Some credits are refundable, meaning they can reduce your tax bill below zero and result in a refund, while others are nonrefundable and can only reduce your tax bill to zero
Both deductions and credits are available to individuals and businesses, and they can significantly lower your tax liability or increase your refund
. In summary:
- Deductions reduce taxable income, lowering your tax bill indirectly.
- Credits reduce tax owed directly, dollar for dollar.
Together, they help minimize the amount of taxes you owe each year
