One of the most fundamental items you need to know to have even a basic understanding of taxation is the difference between a tax credit and a tax deduction. You’ll hear these two items discussed quite frequently, but we’re struck by how often people mix them up or use them interchangeably when they are dramatically different.
Tax Credit
A tax credit is a dollar-for-dollar reduction of your tax liability (another item of terminology: you tax liability is the total tax amount owed on your tax return). A $1 dollar tax credit is worth the same as $1 dollar in cash. So if you owe $1,000 with your return and you have a $1,000 tax credit, that covers the entire liability and you don’t have to send the IRS a check for anything.
Tax Deduction
A tax deduction is worth only a fraction of what a tax credit is worth. A $1 dollar tax deduction reduces the amount of income you’ll be taxed on by $1 dollar. This deduction occurs before the tax rate is applied, so depending on your marginal tax bracket (tax rate), a $1 tax deduction could be worth maybe 25 cents.
A tax deduction that most people are aware of is the mortgage interest deduction. So let’s say you earn $70,000 and you have $15,000 of deductions, your taxable income subject to the tax rate in this example would be $55,000. The tax rate is then applied against the $55k and that gets you to your tax liability.
When people talk about “writing something off” on their taxes, they really mean they are going to take it as a deduction.
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