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Time for pop quiz. Do tax credits or deductions save you more money? And now, what is the difference between exemptions and exclusions? If you’re stumbling for an explanation, it’s understandable, given all the jargon tossed around during tax season.
As an IRS-enrolled agent, I know firsthand that understanding these terms can help you keep more of your hard-earned money. I’ll explain these commonly confused tax breaks, provide examples and share strategies for maximizing your tax savings.
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What is the difference between tax credits and deductions?
These two tax terms are probably the ones my clients confuse most often. Think of a tax credit as a gift card applied to your tax bill at checkout and a tax deduction as a discount on your taxable income. Both are valuable, but credits tend to be far more impactful.
Let’s look at an example to help explain.
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Say you’re a single filer who earned $50,000 in 2024 without any deductions or credits. Your taxable income would be $50,000, so you’d owe $6,059 in taxes.
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A $5,000 deduction would reduce your taxable income to $45,000, so you’d owe $5,171 in taxes.
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If you had no deductions but qualified for a $5,000 tax credit, your taxable income would be $50,000. But you would subtract the $5,000 credit from your $6,059 tax bill, so you’d only owe $1,059 in taxes.
I’ve had many clients confuse the two, particularly the mortgage interest deduction. Some clients purchased a home, assuming the deduction would reduce their taxes dollar-for-dollar. In reality, however, you should calculate how much a deduction will save you by multiplying the deduction by your effective tax rate.
For instance, if you pay $20,000 in mortgage interest during the year and have an effective tax rate of 25%, this deduction will save you about $5,000 (20,000 x 0.25) on taxes. If it were a tax credit, you’d save $20,000.
Tax credits
Many tax credits are intentionally targeted to help specific groups of people or to incentivize certain types of behavior. Refundable credits can be even more valuable because they reduce your tax amount to less than zero.
It’s important to note here that even if you don’t qualify for refundable tax credits, but your tax liability is reduced to $0, the IRS will still refund whatever money you paid over the year. Some common tax credits include ones for child care, education, retirement savings contributions and home improvements.
Tax deductions
The vast majority of tax deductions require that you itemize your deductions to take them.
With the passage of the Tax Cuts and Jobs Act of 2017, the standard deduction was increased significantly so that around 90% of American taxpayers benefit more by taking it. The best tax software will guide you step-by-step through each possible deduction and then tell you whether the standard deduction or itemizing will save you the most money.
If you do itemize deductions, some of the most common ones are ones for the mortgage interest deduction, charitable contributions and medical expenses. A few deductions are what we call “above the line” deductions, which can be taken even if you don’t itemize. Some common ones include:
- Student loan interest deduction: Up to $2,500 in student loan interest can be deducted.
- Teacher expenses: Educators can claim up to $300 in out-of-pocket expenses on classroom items like books, supplies and equipment.
- Retirement contributions: Contributions to traditional IRAs and HSAs are deductible under certain conditions.
What is the difference between tax exemptions and exclusions?
Exemptions are exclusions may also sound similar, but they’re very different.
Exemptions
Exemptions are a specific dollar amount that can reduce your taxable income. Prior to the tax reform package passed in 2017, you could claim exemptions for yourself and each of your dependents. Under current tax law, however, these exemption amounts are set to $0 and aren’t used on your federal tax return.
Exclusions
Under the Internal Revenue Code, all income is considered taxable, but Congress can pass laws excluding certain income types.
A common exclusion is the health insurance premiums paid by your employer. While these are part of your compensation package, they are excluded from your income. Many types of academic scholarships are also excluded from income, as are most life insurance proceeds and legitimate gifts you receive from other people.
How can tax filers boost their refund or lower their tax bill?
With just a little planning, you can maximize your tax breaks and your refund. Follow these simple steps to prepare.
- Keep good records. Save paper receipts or use your phone to take a photo and catalog them. These will be for business expenses, charitable donations, medical bills, other taxes you pay, and anything else that could be potential deductions.
- Familiarize yourself with the tax credits and deductions available for your personal situation. If you have children, are lower- to middle-income, or own a home or business, it’s worth educating yourself about the basic requirements for the tax breaks that directly apply to you.
- Be aware of changes in tax law. Congress passes new bills all the time, some of which affect taxes in small ways and others in big ways. Check CNET for the latest news on taxes and how to save money on your taxes.
The tax code may be complex, but the goal is simple: Don’t pay more tax than you legally must.
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