What is the key difference between a tax deduction and a tax credit?

A tax deduction reduces taxable income, which in turn lowers the overall amount of income that is subject to taxation. This means that by claiming a deduction, taxpayers can potentially move into a lower tax bracket, which can lead to reduced overall tax liability. For example, if a taxpayer has a taxable income of $50,000 and claims a $5,000 deduction, their taxable income becomes $45,000. Consequently, the amount of income that is taxed is less, resulting in a lower tax bill.

In contrast, a tax credit is a direct reduction of the tax owed, making it a more straightforward benefit because it decreases the tax liability on a dollar-for-dollar basis. For example, if a taxpayer owes $1,000 in taxes and has a $200 tax credit, their tax liability is directly reduced to $800.

This distinction is crucial because a tax credit can provide a more significant benefit than a deduction since it directly decreases the amount of tax payable rather than just reducing the income that is taxed. While both deductions and credits assist in lowering tax liability, they operate differently in how they affect what taxpayers ultimately owe to the IRS.