Tax Exclusion vs. Tax Deduction vs. Tax Credit

There are several tax reductions that can benefit employers and consumers, such as tax exclusions, deductions, and credits. While some individuals may think they’re the same, each has different structures and effects on income tax liabilities.

So, what are the significant differences between these tax reductions? All three forms can reduce the amount of federal taxes a person owes. However, some reduce your tax liability while others reduce your overall tax bill.

In this article, we’ll review how tax exclusions, tax deductions, and tax credits differ. We’ll also list examples of these reductions so you better understand the various items you can claim during tax season.

In this blog post, you’ll learn:

• The distinctions between tax exclusions, deductions, and credits.
• How exclusions, deductions, and credits affect taxable income and bills.
• Examples of tax-exempt items, deductible expenses, and tax credits that individuals and businesses can claim.

What are tax exclusions?

First, let’s talk about tax exclusions. A tax exclusion reduces the amount of money you report as your gross income, ultimately reducing the total taxes you owe for the year.

Certain forms of compensation are exempt from taxable income, which means you’ll pay no income taxes on the excluded amount. Tax exclusions can include certain forms of retirement income, federal subsidies, insurance benefits, and more.

If your employer offers you a health reimbursement arrangement (HRA), employer contributions to the benefit are exempt from payroll taxes. Additionally, the IRS doesn’t consider employees' HRA reimbursements for medical expenses as taxable income.

What are tax deductions?

Next, let’s look at tax deductions. A tax deduction is an expense you subtract from your gross income when calculating taxable income. This deduction reduces your tax liability in proportion to your federal income tax bracket. There are many tax deductions, so be sure you use them to your greatest advantage¹.

The following are the standard deductions for the 2024 tax season based on filing status:

The IRS generally releases updated standard deductions in November each year.

All eligible taxpayers may subtract certain income or eligible expenses from their total income to get their adjusted gross income. These deductions differ based on filing status or other personal factors. For example, self-employed tax filers may deduct the total cost of their health insurance from their income.

You can determine your liability by calculating which federal income tax bracket you fall into based on your taxable income after making deductions. For the 2024 tax year, these brackets range from 10% to 37%². The value of tax exclusions and deductions generally depends on an individual’s marginal tax rate.

What are tax credits?

Lastly, there are tax credits. Tax credits differ from deductions and exemptions because they directly reduce your tax bill. After calculating your total taxes, you can subtract any qualifying credits to get a lower bill.

There are many different types of credits. But they all use dollar-for-dollar reductions. For example, a $1,000 tax credit reduces your bill by $1,000. Reviewing all your credit options may be time-consuming. But it can be worthwhile for individual taxpayers and business owners.

Many common tax credits are nonrefundable. This means the credit can’t exceed the taxpayer’s income tax liability. Lower-income individuals generally owe less in income taxes. So, they’re less likely to benefit from nonrefundable tax credits.

However, refundable tax credits also exist. This means those who meet the eligibility requirements for the credit can benefit regardless of their liability.

“Tax credits directly lower the amount of tax you owe,” David Fritch, attorney, tax advisor, and CPA at Fritch Law Office, said. “Nonrefundable tax credits can lower your bill down to $0. Refundable credits can provide you with a tax refund. High-income taxpayers typically benefit more from common tax deductions. Lower-income individuals benefit more from credits.”

For example, premium tax credits reduce eligible individuals’ monthly premiums, making health insurance coverage more affordable. Only those who buy an individual health plan on a public health exchange can receive premium tax credits.

Here are some more highlights about premium tax credits:

• Eligible individuals can receive premium tax credits on their federal income tax return. They can also get advance credits to help pay their monthly insurance premiums throughout the year.
• All consumers who buy health insurance on a public exchange will pay no more than 8.5% of their household income for the silver-level benchmark plan through 2025.
• If an individual receives premium tax credits, they usually don't have to pay the credit back during tax time. However, if your income estimation is off and you collect more credits than you qualify for, you’ll have to pay back the difference. Otherwise, you may receive a refundable credit after you file your tax return.

How do HRAs work with premium tax credits?

If your employer offers you an HRA, you may need to reconcile your allowance and tax credits. HRA allowances and premium tax credits can both pay for health insurance premiums. However, employees must coordinate them correctly to be compliant.

The following is how premium tax credits work with HRAs:

1. For 2025, an employee’s qualified small employer HRA (QSEHRA) allowance is affordable if they pay no more than 9.02% of their actual income for the second-lowest-cost silver plan premium on the Marketplace. You can calculate affordability after factoring in your QSEHRA allowance.
   1. If an employee’s QSEHRA is affordable for a given month, they can’t collect their tax credits that month.
   2. If their benefit isn’t affordable for one or more months, they can collect their credits (if they’re eligible). But they must reduce their subsidy by their QSEHRA allowance.
2. In 2025, employees with an individual coverage HRA (ICHRA) must pay no more than 9.02% of their actual income for the lowest-cost silver plan on a public exchange. Employees must choose between the ICHRA and their tax credits—they can’t get both.
   1. Employees should waive their tax credits and opt into the ICHRA if their benefit is affordable. They can opt out of the ICHRA and collect their credits if it's not affordable.
   2. If they opt out of the ICHRA and the benefit is affordable, they still can’t receive their tax credits.

Examples of tax reductions

There are several types of tax credits and deductions that you may be able to claim and many exclusions that may apply to you. While there are many more than included here, we’ve compiled some common tax exclusions, deductions, and credits in the chart below.

You can find a list of taxable and nontaxable income in IRS Publication 525³.

Conclusion

When tax season arrives, everyone wants to know the best ways to lower their taxable income. Consumers can get big savings on their taxes if they know the difference between exclusions, taxes, and credits. However, the process can be confusing initially—especially if it’s your first time. If you have questions while filing your income tax return, consult a tax advisor or financial planner to understand how to get the biggest bang for your buck.

This article was originally published on December 21, 2020. It was last updated on October 7, 2024.

1. Nerdwallet - 2024 standard deductions

2. Nerdwallet - 2024 income tax brackets

3. IRS Publication 525