What is the difference between tax credits and tax deductions?

• A. Deductions reduce taxable income; credits directly reduce tax liability
• B. Deductions directly reduce tax liability; credits reduce taxable income
• C. Both are credits with identical effect
• D. Credits increase tax liability

Answer: (A)

The main idea is that deductions and credits affect your taxes in different ways: deductions lower how much of your income is taxed, while credits reduce the amount of tax you actually owe. A deduction shrinks your taxable income, so the tax you pay is based on a smaller amount of income. The amount you save depends on your marginal tax rate, so the tax savings from a deduction is roughly the deduction amount times your tax rate. A tax credit, on the other hand, subtracts directly from the tax you owe, giving a dollar-for-dollar reduction in your final bill (though some credits are refundable and some are not). Because of this difference, the correct understanding is that deductions reduce taxable income and credits directly reduce tax liability. For clarity, imagine you have $60,000 of income and a $2,000 deduction in a 22% bracket: you’d save about $440 in taxes from the deduction, whereas a $2,000 tax credit would reduce your tax owed by $2,000.