How do tax credits differ from deductions?

• A. Credits reduce taxable income; deductions reduce the tax owed dollar-for-dollar
• B. Deductions reduce tax owed; credits reduce taxable income
• C. Deductions reduce taxable income; credits reduce the tax owed dollar-for-dollar
• D. Credits and deductions have the same effect

Answer: (C)

The main idea is how each option impacts your tax bill. A deduction lowers the amount of income that gets taxed, so it reduces your tax only by a portion of your income based on your tax rate. For example, a $1,000 deduction reduces taxable income by $1,000, and the actual tax saved depends on your bracket.

A tax credit, on the other hand, reduces the tax you owe directly, dollar-for-dollar. So a $1,000 credit cuts your tax bill by $1,000, regardless of what bracket you’re in (though some credits have limits or refundability rules).

That’s why the correct statement says deductions reduce taxable income while credits reduce the tax owed, dollar-for-dollar. Credits and deductions don’t have the same effect because one changes the amount you’re taxed on and the other directly lowers the final tax liability.