Which statement about tax credits and tax deductions is correct?

• A. Tax deduction reduces taxable income; tax credits directly reduce tax payable; credits are generally more valuable as they reduce tax due dollar-for-dollar.
• B. Tax deduction directly reduces tax payable; tax credits increase deductions
• C. Tax deduction is always more valuable than a tax credit
• D. Tax credits increase tax payable

Answer: (D)

Tax deductions reduce taxable income, while tax credits directly reduce the tax you owe. A deduction lowers the amount of income that gets taxed, so the actual tax savings depend on your marginal tax rate—the higher the rate, the more a deduction saves. A tax credit, by contrast, cuts the tax bill itself dollar for dollar, and is often more valuable because it applies regardless of the rate you were taxed at for income. Some credits are refundable, meaning you can receive more back than your tax liability, while nonrefundable credits can only reduce tax to zero. The statement that tax credits increase tax payable isn’t correct; credits decrease tax owed, with the caveat that the exact benefit of a deduction varies with your income and bracket.