Tax credits and deductions both offer a break on your tax liability. But there are important differences between the two.
A credit reduces your tax bill dollar-for-dollar. A deduction lowers your taxable income, and the value of that reduction depends on your tax bracket.
Some of these tax credits are even refundable.
1. Child Tax Credit
Raising children is a huge financial commitment, but there are tax breaks that can help parents. One of them is the Child Tax Credit, which can reduce a taxpayer’s tax bill on a dollar-for-dollar basis or even completely eliminate it for some taxpayers.
Congress expanded the credit when it passed President Biden’s American Rescue Plan in March 2021, which provided tens of millions of families with breathing room and dramatically cut child poverty. However, the credit reverted back to pre-Rescue Plan requirements in January 2022 and those families will see smaller refund checks next year.
If you are one of those affected, consider putting your refund into a savings account for your kids or investing it into their education through a 529 college saving account. A financial planner can guide you on the best way to do so.
2. Earned Income Credit
The Earned Income Credit helps low- to moderate-income workers and their families get a tax break. It can reduce the amount of taxes owed and even result in a refund.
Unlike tax deductions, which indirectly lower your income tax bill by lowering your taxable income, tax credits reduce your tax bill dollar for dollar. This makes them more powerful than tax deductions and can help you get more money back in your wallet.
The federal EITC and state EITC (CalEITC) provide cash-back benefits to eligible working taxpayers based on their New York recalculated federal adjusted gross income, filing status and family size. These credits have significantly reduced poverty and boosted family incomes. They have also helped cut government spending on means-tested public assistance programs, such as food stamps and Temporary Assistance for Needy Families.
3. Earned Income Exclusion
A tax deduction reduces the amount of your income subject to tax, which is your taxable income found on line 15 of Form 1040. This is a more indirect way of cutting your taxes, compared to tax credits, which directly lower your actual tax liability.
Tax credits, such as the earned income credit, are refundable, which means you can get part or even the entire value of the credit back even if you have no tax liability. Non-refundable tax credits, such as the standard deduction, can also lower your taxable income, but they won’t increase your refund. If you work abroad, you may qualify to exclude the value of meals and lodging provided by your employer on its premises and for its convenience. You must meet the bona fide residence or physical presence test to do this.
4. Earned Income Deduction
The Earned Income Tax Credit (EITC or EIC) reduces the amount of tax owed for working people with low to moderate income. It can also result in a refund.
Tax credits differ from tax deductions in that they directly reduce a taxpayer’s income tax liability, while tax deductions only lower taxable income. Thus, for someone in the 22% tax bracket, a $1,000 credit saves her $220 in federal taxes, whereas a $1,000 deduction only reduces her taxable income by $1.
Taxpayers can choose to claim the standard deduction based on their filing status or itemize deductions such as charitable donations, mortgage interest, state and local taxes, medical expenses, and investment fees. NerdWallet’s income tax calculator helps taxpayers determine whether they should itemize or use the standard deduction — which can save them thousands of dollars at tax time.
5. Additional Child Tax Credit
A tax credit directly reduces what you owe the IRS. It’s different from a tax deduction, which only lowers how much of your income is subject to taxes.
The American Rescue Plan temporarily increased the CTC in 2021, allowing families to claim up to $3,600 for each child under 6 and $3,000 for children ages 6 to 17. However, it has since returned to its pre-pandemic form for tax year 2023.
The refundable portion of the CTC is available to low-income families who aren’t able to fully use their nonrefundable credit. This credit can reduce their tax bill on a dollar-for-dollar basis or even eliminate their tax bill completely. This can result in a refund check from the IRS. NWLC research demonstrates that advance child tax credit payments are linked to food security for women of color.