Definition
Tax credits are direct deductions from a taxpayer’s liability, reducing the actual taxes owed dollar for dollar. Tax deductions, on the other hand, reduce the amount of income that is subject to taxation, not the tax itself. Therefore, while both can lower your tax burden, tax credits typically offer more savings as they directly reduce the amount you owe.
Key Takeaways
- Tax Credits directly reduce the amount of tax you owe, offering a dollar-for-dollar reduction of your income tax liability. This means a $1,000 tax credit saves you $1,000 in taxes. On the other hand, tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket.
- Types of tax credits include the Earned Income Tax Credit, the Child and Dependent Care Credit, and the American Opportunity Tax Credit. Conversely, common tax deductions include the Student Loan Interest Deduction, the Medical and Dental Expenses Deduction, and the State and Local Taxes (SALT) Deduction.
- To maximize your tax savings, it is important to understand which of these two would be more beneficial to your specific financial situation. Generally, tax credits are usually more valuable than tax deductions because credits reduce your tax bill directly.
Importance
The finance terms: Tax Credits and Tax Deductions are important because they directly impact the amount of tax an individual or a business owes to the government. Tax Credits and Tax Deductions both lower the overall tax liability, but in different ways.
A tax deduction reduces the amount of income that is subject to tax, effectively lowering the total taxable income and thereby lessening the amount of tax paid. On the other hand, a tax credit is a dollar-for-dollar reduction of the actual tax bill.
This means, if you have a tax credit of $1000, your total tax bill will be reduced by that exact amount. Understanding the difference between Tax Credits and Tax Deductions can help taxpayers effectively lower their tax liability and potentially save a substantial amount of money.
Explanation
Tax credits and tax deductions are both tools implemented in the tax system with the purpose of reducing an individual’s overall tax liability. However, they work in different ways. A tax credit directly reduces the amount of tax you owe, offering a dollar-for-dollar reduction on the total tax bill. Tax credits are specifically used as an incentive for certain behaviors such as installing energy-efficient equipment at home or higher education expenses.
They aim to lessen the burden for low and middle-income households and stimulate economic growth. These can be either refundable (meaning they can reduce your tax liability to below zero, resulting in a refund) or non-refundable. On the other hand, tax deductions decrease how much of your income is subject to taxes. They are subtracted from an individual’s taxable income.
Tax deductions are used to incentivize certain activities or events, such as making charitable donations or some business expenditures. The value of a deduction depends on an individual’s tax bracket. For instance, for someone in the 24% tax bracket, a $1,000 deduction reduces the tax owed by $240. Hence, the main purpose of tax deductions is to reduce the overall taxable income, potentially moving a taxpayer into a lower tax bracket.
Examples of Tax Credits vs Tax Deductions
Homeowner Expenses: If you own a home, you may be eligible for certain tax deductions and credits, like the Mortgage Interest Deduction and Residential Energy Credit. The Mortgage Interest Deduction, a tax deduction, allows you to reduce your taxable income by the amount you’ve paid in mortgage interest throughout the year. On the other hand, the Residential Energy Credit, a tax credit, is a dollar-for-dollar discount on your tax bill for making energy-efficient improvements to your home. If you spent $2,000 on energy-efficient windows, the credit could reduce your tax liability by that amount.
Education Expenses: Tax credits and deductions can also apply in the realm of education. For instance, the American Opportunity Tax Credit (AOTC) allows for a credit of up to $2,500 per student for qualified education expenses, directly reducing the amount you owe in taxes. Alternatively, the Student Loan Interest Deduction, a tax deduction, can lower your taxable income by up to $2,500 to reflect money spent on student loan interest. This means you’re not taxed on that money, but it doesn’t directly reduce your tax bill.
Business Expenses: For business owners, the purchase of major equipment can be considered as either a tax credit or a tax deduction depending on how it’s financed and claimed. For example, the Section 179 Deduction allows businesses to deduct the full purchase price of qualifying equipment purchased or financed during the tax year. However, if a company were to invest in research and development, they may qualify for the Research & Development Tax Credit. This credit directly reduces their owed taxes, rather than just reducing the taxable income.
Frequently Asked Questions: Tax Credits vs Tax Deductions
What are tax credits?
Tax credits are amounts subtracted directly from your tax liability. They provide dollar-for-dollar reduction in your taxes, meaning if a taxpayer owes $3,000 in taxes and gets $1,000 in tax credits, they now owe $2,000.
What are tax deductions?
Tax deductions are amounts that are substracted from your taxable income. They reduce your taxable income but not your actual tax bill. This means if a taxpayer has a $40,000 taxable income and gets $1,000 in tax deductions, they will only be taxed on $39,000 of income.
What is the difference between tax credits and tax deductions?
The main difference is that tax credits reduce the exact amount of taxes you owe while tax deductions lower your overall taxable income. Thus, tax credits can seem more valuable than deductions as they have a 1:1 dollar value against your tax liability.
Can you claim both tax credits and tax deductions?
Yes, you can claim both tax credits and deductions to minimize your tax liability as long as you meet all qualifications set by the IRS.
Are tax credits better than tax deductions?
It depends. In general, a tax credit is more valuable than a deduction of the same amount because it reduces your tax bill by a dollar-for-dollar amount; whereas, a reduction only decreases your taxable income. However, whether you receive more benefits from credits or deductions largely depends on your individual tax situation.
Related Entrepreneurship Terms
- Adjustable Gross Income: This is your income after adjustments and it forms the basis from which deductions and credits are computed.
- Itemized Deductions: These are expenses that individuals can report on their tax returns to decrease their taxable income.
- Taxable Income: The amount of income used to calculate how much tax an individual or a company owes to the government in one year.
- Non-Refundable Tax Credit: A type of tax credit that’s subtracted from your owed tax amount until the tax you owe is zero. Unlike refundable tax credits, non-refundable ones cannot reduce your tax balance beyond zero.
- Refundable Tax Credit: A tax credit that can result in a refund if it reduces your tax owed to below zero. It means you could potentially get a refund from the government, even if you do not owe any taxes.
Sources for More Information
- Internal Revenue Service (IRS): The IRS is the U.S. government agency responsible for tax collection and tax law enforcement.
- Investopedia: This site is a trusted world-leading source of financial content on the web, with well-researched and knowledgeable articles on Tax Credits vs Tax Deductions.
- NerdWallet: NerdWallet offers financial tools and objective advice to help people understand their options and make the best possible decisions.
- Tax Policy Center: The Tax Policy Center is a joint venture of the Urban Institute and Brookings Institution and provides independent analyses of tax issues.
