Are Tax Credits Better Than Tax Deductions?

As a taxpayer, it helps to do everything you can to lower your ultimate IRS burden. And part of that means capitalizing on key deductions and credits that save you money. The question is: Which will save you more -- tax deductions, or tax credits? And the answer: It depends.

How tax deductions work

Many people use the terms "tax deduction" and "tax credit" interchangeably, when in fact, they work very differently. And once you understand that difference, you'll see why each is valuable in its own right.

A tax deduction is an allowance of sorts that exempts a portion of your income from taxes. If you claim a $1,000 deduction, that means you don't pay taxes on $1,000 in earnings. How much money will that actually save you? Well, it depends on your tax rate. If that rate is 24%, you'll save $240. If it's 32%, you'll save $320. In other words, the more tax you usually pay on your income, the more valuable a given deduction will be.

In fact, you'll often hear that tax deductions heavily favor the rich, and that's not necessarily false. Higher earners, by nature, will get more savings from deductions than lower earners because of their higher tax rates. But earners across all income levels can still go after the deductions they're entitled to -- being a lower earner doesn't exclude you from claiming something you're eligible for.

For example, effective in 2018, you're allowed to claim interest on a mortgage of up to $750,000. If you're a low or middle earner, you probably don't have a $750,000 mortgage, which means that if you claim a mortgage interest deduction, it'll likely be lower than that of someone wealthy. On top of that, if your tax rate is 22% and someone else's is 35%, that person will get more from his or her deductions by virtue of that higher tax rate. That's just how tax deductions work.

How tax credits work

Now let's talk about tax credits. A tax credit is a dollar-for-dollar reduction of your tax liability, and its associated savings have nothing to do with the tax rate you're subject to. In other words, a $1,000 tax credit will lower your tax burden by $1,000 whether you're a low earner, a high earner, or somewhere in between. As such, if you're comparing a $1,000 tax credit to a $1,000 tax deduction, the former will ultimately save you more money.

Aim to reap as much savings as possible

If you're wondering whether it pays to focus on claiming tax deductions versus credits, the answer is: Go after both. Remember, there are requirements you'll need to meet when it comes to claiming credits, and if you're a higher earner, chances are, many of them will be off the table, whereas you might still manage to snag a bunch of deductions.

But deductions aren't a given, either. Though there are some you can claim without itemizing, many require you to forgo the standard deduction and itemize instead. And since the standard deduction rose substantially in 2018, itemizing may not make sense even if you've done it in the past.

The point, therefore, is to aim to eke out as much tax savings as you can when filing your return, whether that means claiming deductions, credits, or both. At the end of the day, you want to pay the IRS as little as possible, no matter how you get there.

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