Does a Tax Deduction and a Tax Credit Result in the Same Tax Benefit?

Tax lingo, even without getting into the weeds of the Internal Revenue Code, tax regulations, IRS rulings, etc., can be confusing. Two frequently used terms that taxpayers sometimes think provide the same tax benefit, but don’t, are “tax deductions” and “tax credits.” Although a tax deduction and a tax credit both help lower the taxpayer’s tax, there’s a difference between them, and there are distinct types of deductions and categories of credits. This article explains these terms. In general, a deduction reduces taxable income, whereas a credit reduces the tax itself.

Tax Deductions – Tax deductions reduce the taxable portion of an individual’s income, which then reduces the tax on that income. But tax deductions come in a variety of flavors, as explained next:

Itemized Deductions – When taxpayers think of deductions, they typically think of the itemized deductions that are claimed on Schedule A. This is the only way to deduct personal expenses such as medical costs, state and local tax payments, investment and home-mortgage interest, charitable contributions (in most years), disaster-casualty losses, and various rarely encountered expenses. In some cases, itemized deductions are limited. For instance, medical expenses are only deductible to the extent they exceed 7.5% of the taxpayer’s adjusted gross income (AGI). Similarly, state and local tax payments (including those for income, sales, and property taxes) are currently capped at $10,000. However, pending legislation may increase or eliminate that limitation. For any change, please contact this office. On top of that, itemization only reduces taxable income to the extent that the total of the itemized deductions exceeds the standard deduction. When the sum does not exceed the standard deduction, the itemized deductible expenses provide no tax benefits at all.

Above-the-Line Deductions – Certain deductions actually reduce income. These are commonly called above-the-line deductions because, when applied, they reduce the income figure that is used to calculate AGI. Thus, their benefits apply regardless of whether the taxpayer uses itemized deductions. Above-the-line deductions include educators’ expenses; contributions to health savings accounts, traditional IRAs, and certain qualified retirement plans; deductible alimony payments; and student-loan interest. Most of these deductions have annual maximums (not discussed in this article).

Below-the-Line Deductions – These are deductions allowed without having to itemize that reduce a taxpayer’s taxable income but not their AGI. For example, for 2021 taxpayers who don’t itemize their deductions are allowed a limited deduction for cash charitable contributions. That donation to charity is a below-the-line deduction. Normally, charitable contributions are only allowed when itemizing on Schedule A.

Tax Credits – Tax credits come in several varieties, and the amount of benefit can vary: