Tax Credit vs. Tax Deduction
A tax credit is not the same as a tax deduction.
Tax Deduction
A tax deduction, such as contributions to a Traditional IRA or 401(k), reduces your adjusted gross income. How much that deduction is worth to you depends on your marginal income tax rate (2008 Federal Tax Brackets).
If you are in the 25% tax bracket, a $1000 tax deduction means you will pay $250 less tax that year. If you are in the 10% bracket, a $1000 tax deduction means you’ll pay $100 less tax that year. If you have a simple tax situation, with little income outside of your regular job, this translates to a larger tax refund.
Common tax deductions are the two mentioned before, Traditional IRA and 401(k) contributions, as well as mortgage loan interest, student loan interest, and charitable donations.
Tax Credits
A tax credit is a dollar for dollar reduction in your income taxes. If you have a $1000 tax credit, you will pay $1000 less tax that year regardless of your tax bracket. A good example is the $1000 child tax credit. If your child applies and you don’t exceed the income limits, you get $1000 for each dependent child you claim on your tax return.
Common tax credits are the child tax credit, Hope Scholarship and Lifetime Learning Credits (education related), retirement savings credit, and the adoption tax credit.
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There are 5 comments, add your thoughts now!
It is worth mentioning that some credits are refundable while others are not. A refundable credit will give you a refund if it reduces your tax liability below $0 while a non-refundable credit will be reduced if it would have made your tax liability below $0.
Example:
If I would be due to pay $900 in taxes in a year and receive a $1000 refundable credit, I would get all the money I had put in for taxes back and an additional $100. If the credit was non-refundable, I would only get the money I had put in for taxes back.
There are some definite tax advantages in being a business owner. There are so many expenses that you may be able to deduct to reduce your taxable income. I just started my investment journey and as I am still learning so much about the stock market, I want to minimize any activities that would result in a taxabale event. Although, I believe, the tax amount is less where stocks are concerned, but, there is still a tax that must be paid if any income is generated. I am learning so much on this journey:
Be well.
Jim-
Some deductions are worth more than others.
Deductions that reduce Adjusted Gross Income (AGI), like Traditional IRA and 401(k) contributions and student loan interest, are much more valuable than itemized deductions like mortgage loan interest and charitable donations.
This is because many deductions and credits are “phased out” or disallowed, and certain items of taxable income are increased, based on a taxpayer’s AGI.
You indicate “If you are in the 25% tax bracket, a $1000 tax deduction means you will pay $250 less tax that year”. In the case of a deduction that reduces AGI a $1000 tax deduction could save you a lot more than $250 in federal income tax - possibly as much as $913!
The Wandering Tax Pro
Rob - That’s an excellent point and thank you for sharing it, you are totally right. Reduce your AGI and you might move the needle enough to get access to things you otherwise could’ve have, like Roth IRAs and the like.
For Bobert’s comment, I don’t get it! Why $250 in federal income tax - could be possibly as much as $913! Could you explain more. thanks!
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