Around tax time, it's common to hear phrases such as "tax deduction" or "tax credit" being used interchangeably. While it can be easy to assume that tax deductions are tax credits are the same, they're actually different and they affect your tax liability in different ways. Which one is best to use on your tax return? Here's a primer on the difference between a tax deduction and a tax credit. 

How Does a Tax Deduction Work?

A tax deduction works by reducing the taxable income an individual has to report. Some common tax deductions include student loan interest, moving expenses, self-employment tax, child support, and IRA contributions. The most commonly used tax deduction is the standard deduction that is automatically granted based on the taxpayer's filing status. Taxpayers who use these deductions can subtract them from their gross income, which indirectly reduces their potential tax liability.

For example, in 2013 a single person who earns $30,000 in total income is eligible to deduct $6100 as his or her standard deduction. If this is the only tax deduction he or she qualifies for, then the adjusted gross income for the year will be $23,900 (30,000 - 6,100). This means that the taxpayer will only have to calculate tax on $23,900 that year, rather than the original $30,000.

How Does a Tax Credit Work?

A tax credit, though, works differently. Rather than reducing taxable income, a tax credit directly reduces the amount of tax owed. Credits are subtracted from the actual tax liability as calculated on the form. There are both refundable and nonrefundable tax credits. Nonrefundable tax credits can only be used to reduce tax liability. On the other hand, refundable tax credit can be issued as a refund to the taxpayer. For example, the Child Tax Credit is a nonrefundable credit. Those who qualify for the Child Tax Credit can subtract up to $1,000 of their total tax liability for each qualifying child. Since the credit is nonrefundable, though, it can only reduce the tax owed. A taxpayer who owes $2,000 in tax and has three qualifying children, therefore, can only claim a maximum of $2,000 in Child Tax Credit.

However, a refundable tax credit can both reduce the tax liability and be issued as a refund. The Earned Income Credit is an extremely popular refundable tax credit. Those who qualify for it can receive the additional credit as a refund. For example, a taxpayer who owes $2,000 in income tax and is eligible for $3,500 in Earned Income Credit will owe no income tax at all, since $3,500 is larger than $2,000. However, he or she can also receive the additional $1,500 as a refund. Another popular tax credit is the federal solar tax credit or ITC. This credit allows taxpayers to deduct 30% of the cost of installing residential solar panels on their home. 

Both tax deductions and tax credits can be extremely beneficial for taxpayers. They both reduce the amount of tax owed at the end of the year. Understanding the difference, though, can help taxpayers prepare their taxes or plan for their tax liability accordingly.