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Tax credits vs. tax deductions: How they differ

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It’s tax season, and households are confronted by a lot of tax jargon when preparing their returns.

Two types of tax breaks stand out among all the lingo: credits and deductions.

Each lowers your tax liability, which is the total annual tax owed on your income. (That figure can be found on line 24 of Form 1040, the IRS form for individual income tax returns.)

However, credits and deductions reduce tax liability in different ways. Here’s how.

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Tax credits offer a dollar-for-dollar reduction in liability

A tax credit offers a dollar-for-dollar reduction of your taxes. It has the same dollar value for any taxpayer who can claim it.

For example, let’s say you get a $1,000 tax credit and have a $5,000 tax liability. That credit would cut your liability to $4,000.  

Tax credits are generally more valuable to taxpayers than deductions (more on that below), and tend to be more targeted to low- and middle-income households, said Ted Jenkin, a certified financial planner and co-founder of oXYGen Financial, based in Atlanta.

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Tax deductions reduce your taxable income

Tax deductions are a lot more valuable [for people] in the 37% tax bracket than someone in the 10% tax bracket.

Ted Jenkin

certified financial planner and co-founder of oXYGen Financial

Deductions can help you qualify for other tax breaks

One big benefit of such above-the-line deductions: They reduce your “adjusted gross income.”

Adjusted gross income — also known as AGI — somewhat differs from taxable income. (AGI is found on line 11 of Form 1040, while taxable income is line 15.)

Importantly, adjusted gross income interacts with other areas of your tax return — meaning that, by reducing AGI, above-the-line deductions can help save money elsewhere.

“Every dollar that reduces your AGI reduces your taxable income, but it may also help you qualify for other deductions,” according to TaxAct. “Various credits are limited by your AGI as well. In some cases, an adjustment may help you qualify for a tax credit or other tax benefits that you would not receive otherwise.”

A lower AGI may also help seniors reduce Medicare Part B and Part D premiums, for example, which are based on “modified adjusted gross income.” (MAGI is adjusted gross income plus tax-exempt interest.)

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