tax credits vs. tax deductionsAs you prepare your taxes this year, it’s important to understand the key differences between certain tax breaks. Knowing how deductions and credits work can help you make more informed choices about how you fill out your tax return, and help you legally reduce your tax liability as much as legally possible.

What are Deductions?

Deductions reduce your taxable income. When you take a deduction, you are claiming a cost that you can reasonably say reduces the amount of income that you have that should be taxed.

Above the line deductions are those that you take on the first page of your Form 1040. These are expenses that reduce your Adjusted Gross Income (AGI) A good example of an above the line deduction is moving expenses. If you have moved, and you meet certain qualifications, you can use those costs to reduce your income before you have to make the decision to take the standard deduction or itemize your deductions.

Standard deduction vs. itemized deductions: Once you have figure out your (AGI), you need to decide whether to take the standard deduction offered to everyone, based on your filing status, or whether you want to itemize your deductions. In general, if you make generous contributions to charity and you have a mortgage (itemize the deduction for interest), your amounts might exceed the amount of the standard deduction.

There are other tax deductions that you can itemize, such as work-related expenses, medical expenses above 10% of your AGI, and miscellaneous expenses that amount to more than 2% of your AGI. (You can see how above the line deductions that reduce your AGI can make it possible to claim certain itemized deductions.)

For 2015, the standard deduction for single filers is $6,300 and $12,600 for those filing jointly. Filing head of household results in a standard deduction of $9,250. If you add up the items that you can itemize and the amount exceeds your standard deduction, it’s usually better to itemize since you will reduce your taxable income by more.

After you’ve figured all of your deductions, what’s left is your taxable income, which might end up being much less than your gross income.

What are Credits?

Credits, on the other hand, are more like gift cards applied to the amount of tax you owe. After you have determined your final taxable income, the amount of tax you owe is determined. If you have already paid some of your taxes throughout the year, by being withheld from your paycheck or by paying quarterly as a business owner, that reduces what you owe. What’s left over is what you need to pay to the government.

However, you can reduce what you owe with the help of credits. A credit directly reduces what you owe, dollar-for-dollar. There are two main types of credit:

Refundable: These credits can boost your refund. If you have “extra” remaining after a credit has taken your tax liability to $0, that amount is given back to you. So, if you owe $1,500 and have a refundable credit worth $2,000, your tax liability will drop to $0, and you’ll get $500 sent to you from the IRS.
Non-refundable: With a non-refundable credit, the best you can do is see your tax bill reduced to $0. You might have a non-refundable credit worth $2,000, but if you only owe $1,500, you won’t get that “extra” $500 refunded to you. It just disappears.

Some credits are also partially refundable, meaning that a portion might be refunded to you after your tax liability drops to $0, even if you don’t end up with the full amount sent to you.

As you prepare your taxes this year, pay attention to deductions and credits so that you have an idea of what to expect, and how to best manage your return.