Tax deductions and Tax Credits

A tax deduction decreases your taxable income.

The IRS only considers certain kinds of income, known as taxable income. Most income is taxable, but some is exempt, like SSI payments, workers’ comp settlements, and some short-term disability benefits. If you made $50,000 of taxable income in 202X but you qualify for $3,000 in tax deductions, the IRS will only tax $47,000 of your income.

What are tax credits?

The IRS applies the tax rates to your taxable income to find how much tax you owe for the year. A tax credit directly decreases how much you owe. If the IRS determines you should have paid $3,000 of income tax in 202X but you qualify for $2,000 of tax credits, now you only owe $1,000.

There are also two kinds of credits: refundable and nonrefundable.

A nonrefundable credit will bring your tax liability to $0, and that’s it. If you owe $1,000 in tax but claim a $1,500 credit, getting a nonrefundable credit means you owe nothing.

A refundable credit would give you a $500 refund, so that you get the full credit. Keep in mind that most people pay income taxes throughout the year from their paychecks, and most people pay more than they need to, so they get a tax refund anyway.

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