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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 [3]. How much that deduction is worth to you depends on your marginal income tax rate (2008 Federal Tax Brackets [4]).

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 [5]. 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 [6], and the adoption tax credit [7].