It’s not uncommon to start thinking about taxes this time of year, as well as tax breaks. Indeed, I recently received this question from a reader:
What’s the difference between a tax credit and a tax deduction?
This is a very interesting question, and one that can actually affect how your taxes come out. Here are the basics of the differences between tax credits and tax deductions:
- Tax deduction: I tax deduction is something that reduces your taxable income. This comes out before you figure out how much you owe in taxes. You take deductions on the front part of your 1040 form, lowering your income. Then when you turn over the form, you take more deductions, starting from your adjusted gross income and reducing, through the standard deduction or through itemized deductions, the amount of income that you are taxed. So, you might have made $80,000 last year, but after your deductions, your taxable income may only be $65,000.
- Tax credit: A tax credit is like a gift card. It’s applied to the balance of your taxable income. So if your taxable income is $65,000, you owe $8,919 if you are married filing jointly. (You can use the tax table found at the IRS web site to look this up.) With credits, you start applying them to the total. For instance, you might be eligible for a tax credit of $1,000. That is applied to your total, lowering what you owe to $7,919.
Of course, if you have part of your money withheld at work, then that is applied to what you owe at this point, so if you have already paid more than what you owe, you will end up with a tax return. You can also see how helpful deductions are. Without the deduction, your taxable income for $80,000 would have been $12,381. Your deductions lowered how much you owe, and then the credits helped further.
Image source: U.S. government via Wikimedia Commons