What is the difference between tax deductions and tax credits?

Both tax credits and deductions can help you save money on your taxes, but there are important distinctions between these two types of tax breaks.

Tax deductions work by reducing your taxable income before you calculate the taxes you owe. So, for instance, if you made $55,000 last year, a $2,000 deduction would lower your taxable income to $53,000. In some cases, this can bring you down to a lower tax bracket, and reduce your income tax rate. People who itemize their taxes — meaning they claim specific deductions instead of the standard deduction — do so to lower their taxable income.

Tax credits, on the other hand, work by reducing the amount of tax you owe — and may even boost your tax refund amount. For example, if you owe $1,500 in taxes and are eligible for $2,500 in tax credits, your tax bill would be eliminated. You could even end up with a refund of up to $1,000.

Whether or not a tax credit will boost your refund depends on if the credit is refundable. Refundable credits let you apply all or part of the credit to your refund, while non-refundable credits will only lower your tax bill.

So, if you owe $500 in taxes and are eligible for $1,500 in non-refundable tax credits, you’ll no longer owe the IRS taxes, but you won’t receive a refund.

Business tax deductions and credits work the same way: deductions reduce your taxable income, while credits reduce the amount you owe in taxes.