Tax Time: The Difference Between Tax Deduction And Tax Credit.
Posted: January 20th, 2011 | Author: Joe | Filed under: Taxes, Tips | Tags: Tax Returns, Tax Time, Taxes | 3 Comments »Knowing the difference between a tax credit and a tax deduction can mean the difference between owing taxes in April and having Uncle Sam send a little of the green stuff your way.
Tax Deductions.
To understand tax deductions, is to understand the term: Adjusted Gross Income, or AGI.
Tax brackets are based on your AGI, and your income tax rate (percentage of income you pay in taxes) is applied to your adjusted gross income.
Your AGI is simply your total income, minus any deductions. Deductions allow you to lower your taxable income, as far as your tax bill is concerned.
Tax deductions come in four main flavors:
- Above the line.
- Schedule C.
- Itemized.
- Standard.
Above the line deductions go directly toward reducing your taxable income, and bringing it down to your AGI. The resulting income, adjusted by the subtraction of the above the line tax deductions, is what determines your eligibility for other tax breaks.
Schedule C (F, and E) are deductions for businesses, Farmers (F) and rental property (E).
Itemized and Standard cannot be taken together. you must chose one or the other, and most people chose Standard. The Standard deduction is like an average, plain Jane vanilla deduction. Itemized deductions are individual and specific deductions that you should be able to support with receipts and records (hence why most people opt for the standard deduction). Also, many people simply don’t qualify for the itemized deductions.
Tax Credits.
While deductions reduce the amount of income that is taxable, credits reduce your tax bill directly. Your tax rate (determined in part by your tax bracket) is applied to your AGI and so a deduction is worth a varying amount dependent upon your rate. Tax credits on the other hand are a dollar-for-dollar reduction in what you owe.
For example, let’s keep things simple and assume you and your spouse file jointly and have an AGI (after all deductions) of $40,000. She’s a stay at home mom and you have 3 children. Your tax bracket for 2010 is 15%. This means that you owe $6,000 in taxes. But not so fast! You forgot to subtract you $1,000 per child tax credit.
With 3 children, that’s a total credit of $3,000.
That $3,000 comes off the taxes you owe – not your income. That would leave you owing $3,000 in taxes instead of $6,000.
By the numbers.
If we look at the difference of a deduction vs. a credit, using our hypothetical couple filing jointly with an AGI of $40,000 we’d see the difference quite clearly:
Taxes owed on $40,000 at 15% :
40,000 * 0.15 = $6,000
Taxes owed on $40,000 at 15% with a $3,000 tax deduction:
(40,000 – 3,000) * 0.15 = $5,550.
Taxes owed on $40,000 at 15% with a $3,000 tax credit:
40,000 * 0.15 = $6,000
(same as with no deduction, but NOW we apply the credit)
$6,000 – $3,000 = $3,000.
I think you can see why a tax credit is more valuable than a tax deduction. 
Happy filing!
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