The Difference Between Tax Deductions and Credits
November 18, 2016 : Mike Slack - The Tax Institute
Editor’s Note: What is a tax credit? What is a tax deduction? Tax expert Mike Slack defines these two concepts in simple terms.
There are few words that get used more than “deduction” and “credit” when it comes to taxes. It is not uncommon to think these words mean the same thing and are interchangeable. However, while both are considered to be tax benefits, the ways they work are completely different…
What is a Tax Deduction?
Simply put, a deduction reduces the amount of your income that gets taxed.
What is a Tax Credit?
A tax credit directly is a dollar-for-dollar reduction of the amount of tax you owe.
Still think tax deductions and credits are the same thing? Don’t worry… we’re here to help. And the best way to understand them is through real-world examples.
Let’s start with tax deductions… Suppose someone is in the 15% tax bracket and discovers they are eligible for a $1,000 deduction. While this reduces their taxable income by $1,000, it will only reduce the amount of actual tax owed by $150 ($1,000 X 15%).
With deductions, the benefit is limited to the amount multiplied by your tax rate.
Tax credits, on the other hand, function to reduce the amount of your tax after you have figured your taxable income. That is, a $1 credit will increase your refund or reduce the amount you owe by $1.
Presume the person in the first example is single and their taxable income is $29,000, meaning they’re liable for approximately $4,000 in tax. If they are eligible for a $1,000 credit, it will directly reduce their liability. Thus, their taxes will go reduce from $4,000 to $3,000.
While tax credits are typically more beneficial than tax deductions, there are far fewer of them, and often less people qualify for them. The best advice is always to try to have an optimized combination of both to yield the best tax benefits.
To help get the best results on your taxes, to connect with a tax professional. They can help you better understand complex tax laws – and help answer questions like “What is a tax credit?” or “What is a tax deduction?”
For a DIY approach, learn more about H&R Block’s free tax e-filing option.