As Tax Day draws closer, many are looking for documentation and trying to figure out whether they are taking a deduction or credit for each item that they hope will bring a tax advantage.
Understanding the difference between a tax deduction and a tax credit is important — especially when you stop to consider that one is more valuable than the other.
Is That a Deduction or a Credit?
The difference between a tax deduction and a tax credit can be expressed by the way it affects your taxes.
Tax deduction:
This lowers your taxable income.
Deductions are taken before your final income is figured out.
There are different types of tax deductions. The first is an above the line deduction, which takes place before you figure out your adjusted gross income (AGI). You report your total income, and then subtract your deductions, arriving at your AGI.
The second group of deductions are taken from your AGI.
After you have figured out your AGI, you flip over your Form 1040, and begin taking other deductions. You can choose to take the standard deduction, or you can itemize your deductions. Add up what you would itemize (using Schedule A), and see if that number exceeds the standard deduction. You want to choose the larger of your itemized deductions or your standard deduction.
Your second round of deductions are subtracted from your AGI.
The result is your taxable income. In many cases, your taxable income is thousands — or even tens of thousands — less than your actual income. A tax deduction helps you by reducing the amount of money that you have to pay taxes on.
Tax credit:
After you have figured out your taxable income, you use that number to see how much you owe in taxes.
Your income can be found on the tax table, and that will provide you with how much you owe. Once you know how much money you owe, you subtract the amount of money you have already paid in taxes, including money withheld from your paycheck and money paid in quarterly taxes.
Now it’s time to add in your tax credits.
The great thing about a tax credit is that it directly reduces what you owe.
This is a dollar for dollar reduction. If you owe $1,000, and you have $500 in tax credits, you only owe $500 total. Having a tax credits is like having a gift card meant to help you pay your taxes.
So, Which is More Valuable?
As you might imagine, having a tax credit is more valuable.
A tax deduction is helpful, since it lowers your taxable income, but it isn’t quite the same. Your deduction might not be enough to knock you down a tax bracket, and it simply reduces the amount of money your taxes are figured on.
A $100 tax deduction isn’t worth $100, since it might only lower your taxable income from $55,000 to $54,900. That makes a difference of $15 when you go to pay your taxes if you are married filing jointly. (According to the IRS tax table, you would owe $7,416 and $7,401, respectively.)
A credit, though, translates directly into dollars saved.
If you have a $100 tax credit, you have a $100 tax credit. It means that if you owe $7,401, and you apply the credit, now you owe $7,301.
Of course, if you have already paid your taxes, you could end up with a tax refund. The Earned Income Credit and some other credits can result in the government owing you money after all is said and done.
Good post, I think this topic is very confusing to many taxpayers. You did a nice job of clarifying the differences.
And the best ones are the refundable ones–those that not only erase what you paid, but can also be dispersed over and beyond $0. The American Opportunity Tax Credit is one such credit…up to $1000 refundable.
Wouldn’t it be easier to give people tax deductions rather than tax credits? Say, give people a deduction for rent, furniture, appliances, utilities, food, clothing, discretionary spending, etc.
“Easier”? What does that mean? I don’t see why deductions are easier than credits. Sure, you could give a deduction for all sorts of things, but then you’d explode the federal deficit.
Contrary to easy, deductions & credits are actually what make taxes difficult. It’s what you need to keep receipts for, and remember to enter, learn what the new ones are, learn which old ones are expired, what criteria you have to meet in order to quality, etc.
If you really wanted to make things easier, you would reduce/eliminate all the various deductions & credits and lower the rates to keep total tax revenue to the same.
… none of this should take away from Miranda’s excellent explanation of course 🙂
Thanks for the information. Really helpful to have it explained and laid out this way.
Do all states accept the pre-tax deductions to be deducted from the gross wages to get to taxable wages?
Every state has their own rules as to which federal deductions they accept. Many states also have additional deductions that don’t apply federally (rent, social security, & tolls are ones I’ve personally experienced).
in my opinion tax credit is better!
thank you for being clear and concise
I agree that for most a credit is far better. And although you touched on the tax bracket issue, I think it should be made more clear. If you are on the “boarder” of a tax bracket the deduction may be more useful. When you have a choice between taking a credit or a deduction you just have to do the math. Blindly choosing one over the other may cost you.
Not true… unless the tax bracket is 100% or greater.
I think you may be confused about tax brackets… when you go to a higher one, all your income isn’t suddenly taxed at the higher rate. Rather only the amount above the cutoff is taxed at the higher rate.
For instance, lets take a simple example and say that the bracket is 10% under $10K and 15% above it.
In this example, if you have $10K in taxable income, you pay $1000 in taxes. However, if you make $11K, you do *not* pay 15%*11,000 = $1650 in taxes. No, you pay 10% on the first $10K ($1000) pus 15% on the next $1K ($15) for a total of $1150.
A deduction can never be more valuable than a credit of the same amount… not unless there’s a tax bracket above 100%.