Taxes:
What are the 5 huge differences between a Tax Deduction and a Tax Credit?
Effect on Taxable Income vs. Tax Liability
A tax deduction reduces your taxable income, which is the amount of income subject to tax. For example, if you earn $50,000 and claim a $2,000 deduction, your taxable income drops to $48,000. This reduction in taxable income lowers the amount of tax you owe based on your marginal tax rate.
In contrast, a tax credit directly reduces your tax liability, which is the total amount of tax you owe. If you owe $5,000 in taxes and claim a $2,000 tax credit, your tax bill is reduced to $3,000. Tax credits are typically more beneficial because they provide a dollar-for-dollar reduction in your tax liability.
Refundable vs. Non-Refundable Credits
Tax credits can be either refundable or non-refundable, which adds another layer of distinction. A non-refundable tax credit can reduce your tax liability to zero, but it cannot result in a tax refund. If your tax liability is $500 and you claim a $1,000 non-refundable credit, your liability becomes zero, but you do not receive the remaining $500. On the other hand, a refundable tax credit can reduce your tax liability to below zero, resulting in a tax refund. Using the same example, if you claim a $1,000 refundable credit, your liability becomes zero, and you receive a $500 refund.
Tax deductions do not have this distinction since they only reduce taxable income.
Eligibility and Phase-Outs
Eligibility criteria and phase-out limits for tax deductions and credits can vary significantly. Deductions often have broader eligibility criteria but can be subject to income phase-outs or limits. For instance, the deduction for student loan interest is available to many taxpayers but begins to phase out at higher income levels.
Tax credits, especially refundable ones, often have stricter eligibility requirements and phase-outs. For example, the Earned Income Tax Credit (EITC) has specific income limits and requirements based on filing status and the number of qualifying children. Understanding these distinctions helps in determining which benefits you qualify for and how to optimize your tax situation.
Impact on Tax Brackets
Because tax deductions reduce your taxable income, they can also affect your tax bracket. Lowering your taxable income might move you into a lower tax bracket, reducing the marginal tax rate applied to your income. For example, if a deduction lowers your taxable income enough to drop you from a 22% to a 12% tax bracket, your overall tax liability decreases more significantly.
Tax credits, however, do not impact your taxable income or tax bracket; they directly reduce your tax liability regardless of your income level. This means credits provide the same benefit regardless of your tax bracket, while deductions offer more significant savings at higher marginal tax rates.
Types and Purposes
The types and purposes of tax deductions and credits vary widely. Deductions are often related to expenses incurred for earning income or for personal expenses recognized by the tax code, such as mortgage interest, medical expenses, and charitable contributions. They aim to acknowledge and reduce the financial burden of these expenses.
Tax credits, on the other hand, are designed to incentivize specific behaviors or provide financial relief for certain circumstances. For instance, the Child Tax Credit supports families with children, the American Opportunity Tax Credit encourages education, and energy efficiency credits promote environmentally friendly practices. The intent behind credits is more targeted, aiming to achieve specific policy goals.
