What is a Tax Deduction and How Does it Differ from a Tax Credit?
A tax deduction is a sum of money that you can subtract from your taxable income. A tax credit, on the other hand, is a sum of money that you can subtract from your taxes owed. Although they are both ways to lessen the amount of money you owe to the government in taxes, they differ in a few key ways. Read on to find out how a tax deduction and a tax credit work and how they differ from one another.
Tax deductions – Taking a closer look
A tax deduction is the amount of money deducted from your taxable income for a particular expense. This amount will then be subtracted from the total income that you are taxed on. It is one of the ways that you can lower your taxable income, which will reduce the taxes you owe.
The Internal Revenue Service (IRS) allows taxpayers to reduce their tax by claiming different “allowable” deductions on their income.
What is a tax credit?
A tax credit is a direct dollar-for-dollar reduction of the income tax owed. In simple terms, if your net tax due after factoring in all deductions is $1,500 and you qualify for tax credits of $1,000, your net tax due will be $500 if all credits are applied.
Examples of tax credits are Child Tax Credit, Adoption credit, Earned Income, American Opportunity Tax credit, etc.
How does a Tax Deduction Differ from a Tax Credit?
Based on the previous definitions, the major difference between Tax reductions and Tax credits has to do with their impact on taxable income, as well as the final tax liability.
Tax deductions reduce the amount of income subject to tax, while tax credits directly reduce the amount of tax you owe.
A tax deduction is the amount of money deducted from your taxable income for a particular expense. This amount will then be subtracted from the total income that you are taxed on. For example, if you are in the 25% tax bracket and have $1,000 in expenses, you would get a $250 deduction. When doing your taxes, this deduction will lower your total taxable income by $1,000.
On the other hand, a tax credit will result in a dollar-for-dollar reduction of the tax due. For example, if the calculated tax due is $2,000 and you apply $1,500, the net tax due will be $500.
Who Can Claim a Tax Deductions and in What Situations?
While some tax deductions are available to everyone who files a federal income tax return, other kinds of deductions may be limited to certain kinds of taxpayers or depend on a taxpayer’s circumstances. For instance, a taxpayer who qualifies as a low-income earner would be able to deduct certain expenses if they itemize their deductions. A business may be able to claim certain deductions for expenses associated with their operation.
The IRS website has an entire section on what is a tax deduction and how does it differs from a tax credit that you can reference as necessary.
Conclusion
Knowing the difference between tax deductions and tax credits is important for understanding how your taxes are calculated. Proper recognition and recording of qualifying deductible expenses is very important in determining the correct amount of taxes due. Proper planning of your expenses, including decisions that will enable you to qualify for certain tax credits, are essential to minimize your tax liability much as possible.
Our team at 4sight Advisors LLC is equipped to help you navigate the nuances of the tax code and maximize your benefits. We would like to give you a free 45-minute consultation to discuss how you can earn more using our proven strategies.