A tax deduction and a tax credit are two different types of tax benefits that can help reduce your overall tax liability, but they work in different ways:
Tax Deductions
A tax deduction reduces your taxable income, which in turn reduces the amount of income tax you owe.
When you claim a deduction, you are subtracting a certain amount from your income before your tax liability is calculated. The deduction amount depends on your tax bracket and the type of deduction you are claiming.
For example, if you have taxable income of $50,000 and you claim a $5,000 deduction, your taxable income will be reduced to $45,000. If you’re in the 22% tax bracket, your tax savings would be $1,100 (22% times $5,000).
Common tax deductions include expenses like mortgage interest, charitable donations, and property taxes. For businesses, tax deductions are “ordinary and necessary” (IRS words) expenses for you to operate a business… this is a whole lot of things.
When thinking about tax deductions, remember, it is NOT a dollar for dollar tax reduction. It is the deduction amount times your tax rate. That is your tax savings. Whereas, you’ll read next, a tax credit is dollar for dollar savings.
Tax Credits
A tax credit is a dollar-for-dollar reduction in the amount of tax you owe. Unlike a deduction, which reduces your taxable income, a credit directly reduces your tax liability. The amount of the credit is subtracted from the amount of tax you owe after your taxable income has been calculated.
For example, if you have taxable income of $50,000 and your tax rate is 22%, then your tax will be $11,000. Then, if you receive a $5,000 tax credit, your tax liability would be reduced to $6,000.
Common tax credits include the Child Tax Credit, Earned Income Tax Credit, and the American Opportunity Tax Credit for education expenses.
Recap
Based on the two examples above, a $5,000 tax deduction would save you $1,100, but a $5,000 tax credit would save you $5,000.
Credits are superior (in this example). Hopefully that makes sense!
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