If you are unfamiliar with the topic, taxes can seem very complicated. While this is true in some cases, for the majority of us filing income tax returns should be pretty straightforward. Even if your taxes are easy to complete, there are some basic tax concepts that you should understand. Two of the most important tax related terms are a tax credit and tax deduction. Here, we detail the difference between a tax credit and tax deduction.
What is a tax deduction?
A tax deduction is a dollar for dollar reduction in your taxable income. Even though they are called a tax deduction, a more fitting term is income deduction. This is because a tax deduction is reducing the amount of income you are reporting on your return.
There are many types of tax deductions out there. You may be surprised by what you can use as a deduction as there are many overlooked tax deductions. Some include the mortgage interest deduction and student loan interest deduction. Other types of deductions include professional development related expenses, pet expenses (in some cases), as well as work clothes and uniforms.
Overall, a tax deduction will save you when it comes to how much income tax you will pay. However, calculating your tax savings resulting from a deduction isn’t as easy when compared to a tax credit. To get an estimate of how a deduction will impact your tax liability, just multiply you marginal tax rate by the tax deduction.
For example, lets say you take a $1,000 deduction for student loan interest. Assuming that you are in the 25% income tax bracket, that $1,000 deduction will save you $250 is taxes ($1,000 x .25 = $250).
What is a tax credit?
Like a tax deduction, a tax credit ultimately reduces your tax liability. However, a tax credit is a dollar for dollar reduction in the amount of taxes you owe. For instance, if you buy an electric car and qualify for electric car tax credits in the amount of $5,000, you will save exactly $5,000 from your total income tax liability. This is different from a tax deduction because a deduction only nets you a fraction of that amount at the end.
Just like how there are multiple tax deductions available, there are also a ton of tax credits. Some examples include the child tax credit, earned income credit, and lifetime learning credit.
Deductions and Credits Have Different Impact
Tax deductions and tax credits are similar in the fact that they can save you money on your taxes. However, tax deductions and tax credits impact tax payers differently. Tax deductions and tax credits impacts taxpayers differently and may be more or less equitable depending on how they are deployed. This is a factor that must be taken into consideration when discussing possible tax policy reform.
If you compare how a tax deduction affects two different tax payers, you can see what we mean. A $1,000 deduction for a taxpayer whose marginal tax rate is 39.6% will net a $396 tax savings. However, a tax deduction for a taxpayer whose marginal rate is 25% will yield a $250 tax savings. Even though both taxpayers received the same reduction of taxable income, their tax savings are not the same.
Tax deductions will impact different tax payers differently. On the other hand, tax credits have the same type of impact for the most part. Tax credits are more progressive than tax deductions because they are not dependent on the marginal tax rate of the taxpayer. If anything, higher income earners will not benefit from tax credits at all because these credits usually phaseout as income increases
Tax Credit vs Tax Deduction – Summary
Understanding the difference between a tax credit and tax deduction is very important. Not only will it help you be more knowledgeable when it comes to filing your own taxes, but you will be able to make more sense of potential tax policy reform discussions.
In review, a tax deduction acts as a reduction of your taxable income. The total tax savings from a deduction is dependent on your marginal tax rate. A tax credit reduces, dollar for dollar, the amount of taxes you owe. Depending on the tax credit, there may be an income limit so not all tax payers qualify. The limit may differ for the type of return you file (i.e. single vs. married filing jointly).