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

They are NOT the same thing.

One of them is usually much more valuable than the other.

A tax credit directly reduces the Federal tax amount that you owe, dollar-for-dollar.

A tax deduction reduces your Federal taxable income.

Still not totally clear what this means?

Here’s a great example:

Let’s say you or one of your dependents was in college.

Prior to 2021, there were two different options you may have had:

1) Claiming the American Opportunity CREDIT of $2,500.

2) Claiming the Tuition and Fees DEDUCTION of $4,000

To the naked eye, option 2) seems more valuable – $4,000 is greater than $2,500.

But while the credit will directly reduce the tax that you owe by $2,500, the deduction will only reduce your taxable income by $4,000.

If you’re in the 22% income tax bracket, that amounts to a tax savings of $880 (i.e. $4,000 X 22%).

This is a great example of why tax credits are generally more valuable than tax deductions.