Why a Tax Credit is Better than a Tax Deduction

It is tax time again, and one of the questions I get asked all the time is: which is better, a tax credit or a tax deduction? It's a common question because, let's face it, taxes are confusing. The language is confusing, and the forms are confusing. The IRS just doesn't make anything easy on taxpayers.

So here is the answer:

A tax credit is always better than a tax deduction, because a tax credit lowers your tax bill directly.

A deduction lowers your adjusted gross income, so the amount you get shaved off your tax bill is directly tied to your tax bracket.

Example: Tax Credit vs. Tax Deduction

For example, let's say that you qualify for the American Opportunity Tax Credit (you can get this if you pay for education expenses). This tax credit is for $2,500 if you make less than $80,000 per year.

If you receive the full $2,500 tax credit, you will lower your tax owed to the IRS by $2,500. Simple as that. If your tax bill was going to be $5,000, you just slashed it to $2,500.

However, what would happen if that was a deduction and not a tax credit? A $2,500 deduction, if you are in the 25% tax bracket, will lower your adjusted gross income by $2,500, thereby lowering your tax bill by about $620.

Do you see that difference: a tax credit in this situation would save you $2,500 in taxes, while a tax deduction in this situation would only save you $620 in taxes. That makes the tax credit worth $1,880 more than the tax deduction.

Now that you know the difference, don't worry about it. Instead, compare the best tax software and let the system figure out the best option for you.