Tax Credits vs. Tax Deductions: Here’s What You Need to Know
There is some information about money that is so complicated, you don’t even want to begin the conversation.
And then there’s that information that’s so simple, you assume you’re supposed to know it by now.
But you don’t.
You go through life thinking everyone around you understands these basic principles of personal finance that somehow elude you. And you’re afraid to ask questions, for fear of looking stupid.
You’re not stupid.
Money is complicated as hell. And our education about it is just plain bad.
Part of my job is to ask the questions you’re afraid to ask. And, while I’m at it, I might as well try to answer them, too, right?
Today’s Lesson: Tax Deduction vs. Tax Credit
I’ll start with a basic issue I’ve noticed for years: Many people — intelligent, hard-working, otherwise-savvy adults — do not know the difference between a tax credit and a tax deduction.
If you’re one of them, you don’t have to admit it. Just keep reading.
This information could be worth thousands of dollars to you next April.
What is a Tax Deduction?
“Tax deductions are removed from taxable income (adjusted gross income) and thus lower the overall tax-expense liability,” says Investopedia.
A tax DEDUCTION reduces the amount of income you owe taxes on.
How do you benefit from a tax deduction?
“A (tax) deduction is a reduction of the amount that gets taxed,” explains tax attorney Eric Green.
A deduction can help in one or both of these ways:
- You’ll pay less with a lower taxable income, because you pay taxes as a percentage of taxable income. For example, in the IRS’ second tax bracket ($9,275 through $37,650), you’ll pay $927.50 plus 15% of taxable income over $9,275. So, for $35,000, you’ll pay $4,786.25 in taxes. If you were to take a $3,000 tax deduction, bringing your taxable income to just $32,000, your tax bill will be $4,336.25. In that case, $3,000 in tax deductions would save you $450 on your tax bill.
- You could pay a smaller percentage, because a lower income may fall into a lower tax bracket. In the U.S., your income determines your tax rate. Tax brackets are the cutoff income levels for those rates.
For example, for 2016, if you’re single with income between $9,275 and $37,650, your tax rate is $927.50 plus 15% of taxable income in excess of $9,275. From $37,650 to $91,150, your rate is $5,183.75 plus 25% of your taxable income over $37,650, according to the IRS. (Yes, there is a small overlap in brackets there. Please consult you tax professional to know what bracket you fall in).
So, if your income is $38,000, you’ll owe $5,183.75 plus 25% of $350 ($5,721.25). If your income is $35,000, you’ll owe $927.50 plus 15% of $25,725 ($4,786.25).
In that example, $3,000 in tax deductions would save you $935.
What is a Tax Credit?
“A tax credit is an amount of money that a taxpayer is able to subtract from the amount of tax that they owe to the government,” says Investopedia.
A tax CREDIT reduces the amount of taxes you owe.
How do you benefit from a tax credit?
“A (tax) credit is a dollar-for-dollar reduction of the tax owed,” says Green.
Tax credits are actually much simpler to figure out than tax deductions. Once you do the math, they’re money in your pocket.
Add together all your tax credits, and subtract that total from what you owe in taxes.
For example, if your taxable income — after deductions (see above) — is $35,000, you would initially owe $4,786.25.
If your college expenses make you eligible for the American Opportunity Tax Credit, you may receive a credit up to $2,500. So you would owe only $2,286.25.
When Will You Use This Information?
These basic facts should, you might expect, come in handy when you’re filing your income tax return next year.
Want to put them to use throughout the year? They actually come up more often than you might realize:
- When your friends criticize a big company for donating to charity as a “tax write-off,” they’re talking about tax deductions.
- When your neighbor gets solar panels you didn’t think he could afford, he’s probably going to get the money back as a tax credit next April.
- When you meet a colleague for Happy Hour, and he offers to pay for your drinks because he can “claim it on his taxes,” he’s expecting a tax deduction. (He’s also wrong, but you can choose whether you like him enough to clarify.)
Where to Learn More
Remember: We are not tax experts by any stretch of the imagination.
The particulars of what makes you eligible for specific tax credits and deductions are unsurprisingly more complicated. But we’ll stop at the basics for today.
If you want to learn more, check out these resources:
- Our list of the eight most overlooked tax deductions and credits
- Nine tax breaks for parents that could save you thousands of dollars
- Five important questions to ask before doing your taxes yourself
- Find out how your state’s tax burden compares with others’
- Before you fill out a W-4, use the IRS Withholding Calculator to estimate how much you’ll owe at the end of the year.
And don’t forget to share this post with your friends! Some of them are probably afraid to ask this question, too.
Your Turn: Be honest… did you know the difference between a tax credit and deduction before today?
Dana Sitar (@danasitar) is a staff writer at The Penny Hoarder. She’s written for Huffington Post, Entrepreneur.com, Writer’s Digest and more, attempting humor wherever it’s allowed (and sometimes where it’s not).