Updated for tax year 2023.
Everyone wants to know the magic trick to lower their tax burden when tax season arrives. You may know tax credits, exemptions, and deductions can help you save on taxes, but how do they work? Are they the same thing, or does each have a distinct purpose? As a taxpayer, can you qualify for all three?
Let’s dig a little deeper into each of these tax benefits.
At a glance:
- Personal and dependent exemptions were suspended in 2018.
- Tax deductions lower taxable income, while tax credits reduce the amount of tax you owe.
- Understanding the differences and how credits and deductions work will help ensure you don’t miss out on any tax-saving opportunities.
What are the differences between tax exemptions, tax deductions, and tax credits?
While preparing your tax return, the first question that may come to mind is how many tax exemptions, deductions, and credits should I claim, and how do I distinguish between them?
Here are some helpful definitions:
- Tax deductions: Claiming a tax deduction reduces your taxable income, lowering the tax amount you owe.
- Tax exemptions: A tax exemption is like a deduction. Exemptions allow you to exclude the tax exemption amount from your income. You might remember claiming personal and dependent exemptions before 2018.
- Tax credits: Rather than reducing your taxable income, tax credits reduce the amount of tax you owe dollar for dollar.
As you can see, exemptions and deductions reduce your taxable income while tax credits reduce the amount of tax you owe. All three are essential items that save you money.
Tax exemptions
Note: Personal and dependent exemptions were suspended through tax year 2025. The following information only applies to tax returns filed before 2018.
Under the tax deductions and exemptions definition, exemptions are portions of your personal or family income exempt from taxation. Before the Tax Cuts and Jobs Act in 2018, the Internal Revenue Code allowed taxpayers to claim exemptions that reduced their taxable income. You could claim personal and dependent exemptions to lower your taxable income, ultimately reducing the total tax you owed for the year. These exemptions were suspended as of 2018, which means you can’t currently claim them for tax year 2023.
In the past, all dependents, including you and your spouse, received exemptions for tax purposes. To the Internal Revenue Service (IRS), dependents are the people for whom you are financially responsible. A higher number of exemptions would reduce your taxable income.
Before 2018, you could reduce your taxable income by multiplying the dollar value of a personal exemption, which was a predetermined amount, by the number of your dependents. For example, in 2017, the personal exemption was $4,050. It was the same amount for your spouse and each dependent as well. As a part of the tax exemption definition, these exemptions were reduced if your adjusted gross income (AGI) exceeded $261,500 in 2017 as a single filer or $313,800 if you were married and filed a joint return.
Since tax exemptions are mostly a thing of the past, let’s look at something a little more exciting — tax deductions.
Tax deductions
There are two types of tax deductions. Both “above-the-line” and “below-the-line” deductions are claimed on IRS Form 1040, U.S. Individual Income Tax Return, even though they impact your income differently.
Above-the-line deductions reduce your adjusted gross income (AGI). Below-the-line deductions are subtracted from your AGI to determine your taxable income. The “line” referred to is your AGI. There are significant differences between their benefit to you.
Deductions above the line are initially more advantageous than below-the-line deductions because they reduce your AGI. Typically, a lower AGI means you have fewer restrictions when it comes to taking advantage of other tax benefits, like below-the-line deductions and various tax credits.
Here are some examples of above-the-line deductions:
- Educator expenses
- Half the self-employment tax
- Health insurance deduction
- Penalties for early withdrawal of CDs and savings accounts
- HSA deductions
- Traditional retirement plan contributions
- Student loan interest deduction
Itemized deductions are considered below the line. These types of tax deductions are limited to the amount of the actual deduction. For example, a $3,000 below-the-line itemized deduction reduces your taxable income by $3,000. If you take the standard deduction, your AGI is reduced by the standard deduction amount designated for the tax year. In 2023, the standard deduction for single filers is $13,850 (for married couples filing jointly, it’s $27,700).
Here’s an example: Josh and Kristen contribute $5,000 to a traditional IRA and give $3,400 to their local church. Neither one of them participates in a retirement plan through their work. The IRA contribution is an above-the-line deduction, and the church gifts are a below-the-line deduction. Josh and Kristen’s combined income before any reductions is $90,000.
The calculations for Josh and Kristen’s taxable income look like this:
$90,000 (gross income) – $5,000 (above-the-line deduction) = $85,000 (AKA “the line”)
$85,000 – $27,700 (standard deduction for married filing jointly) = $57,300 (taxable income)
As you can see, while Josh and Kristen’s church donation is an itemized deduction, the amount ($3,400) is far less than the standard deduction ($27,700). So, their charitable contribution doesn’t provide any tax benefit. They can deduct more by using the standard deduction.
Additionally, Josh and Kristen’s IRA contributions are an above-the-line deduction and provide a tax benefit even though they use the standard deduction.
Remember, below-the-line deductions are only a benefit when their combined total is higher than your standard deduction. Above-the-line deductions are always helpful, whether you choose to itemize or take the standard deduction.
What is a tax credit, and how does it work? How do you get a tax credit?
Tax credits differ from deductions and exemptions because credits reduce your tax bill directly. After calculating your total taxes, you can subtract any credits for which you qualify. Some credits address social concerns for taxpayers, like The Child Tax Credit, and others can influence behavior, like education credits that help with the costs of continuing your education.
Numerous credits are available for a wide range of causes, and all reduce your tax liability dollar for dollar. That means a $1,000 tax credit reduces your tax bill by $1,000. Reviewing all the options may be time-consuming but could prove profitable. That’s why it helps to use a tax preparer like TaxAct® — our tax preparation software asks you interview questions and determines which tax deductions and credits you may qualify for based on your answers. That way, you’re less likely to overlook an important tax break.
Some major tax credits are:
- Child Tax Credit
- Child and Dependent Care Credit
- Earned Income Tax Credit
- Education credits (like the American Opportunity Credit and the Lifetime Learning Credit)
- Foreign tax credit
- Retirement savings contributions credit (Saver’s Credit)
- Residential energy credits
What is an example of a tax credit?
From our previous example, let’s examine how a tax credit can reduce Josh and Kristen’s tax liability. We’ll say Josh and Kristin have two dependent children who both qualify for a Child Tax Credit worth $2,000 each.
First, we need to determine how much tax Josh and Kristen owe. Remember, after deductions, their taxable income was $57,300. In 2023, this would put them in the 12% tax bracket. The first $22,000 they make would be taxed at 10%, and the remaining $35,300 would be taxed at 12%.
Here’s the math:
$22,000 x 10% = $2,200
$35,300 x 12% = $4,236
$2,200 + 4,236 = $6,436 (total income tax owed)
$6,436 (total tax) – $4,000 (total Child Tax Credit) = $2,436 (total tax owed after credits)
Total taxes owed calculation:
Based on the 2023 tax brackets, Josh and Kristen owe $6,436 in taxes. However, they are eligible for the Child Tax Credit since they have two qualifying children as dependents. When that credit is subtracted from their tax liability, their total tax bill is reduced to $2,436.
You can use our tax bracket calculator to determine your tax rate.
The bottom line
Tax deductions and tax credits significantly impact the amount of income tax you owe. It’s crucial to understand the differences and benefits of each, so you aren’t leaving any money on the table.