What is the difference between a tax credit and a tax deduction?

by marion.bernhard , in category: Taxation and Accounting , 9 months ago

What is the difference between a tax credit and a tax deduction?

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1 answer

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by montana , 9 months ago

@marion.bernhard 

A tax credit and a tax deduction are both methods used to reduce a person's taxable income, but they work in different ways:

  1. Tax Credit: A tax credit is a direct reduction of the amount of taxes owed. It is like a dollar-for-dollar reduction in the tax bill. For example, if you have a $500 tax credit, it will directly reduce your tax liability by $500. Tax credits are typically designed to incentivize certain behaviors or provide assistance to specific groups of people. Some common types of tax credits include the Child Tax Credit, Education Tax Credit, and Energy Efficiency Tax Credit.
  2. Tax Deduction: A tax deduction, on the other hand, reduces the taxable income upon which the tax liability is calculated. It reduces the amount of income that is subject to taxes rather than directly reducing the taxes owed. For example, if you have a $1,000 tax deduction and you are in the 20% tax bracket, it would reduce your taxable income by $1,000, resulting in a tax savings of $200 (20% of $1,000). Tax deductions can be categorized as either above-the-line deductions or itemized deductions. Above-the-line deductions are subtracted from the gross income to arrive at the adjusted gross income (AGI), whereas itemized deductions are subtracted from the AGI to determine the taxable income.


In summary, tax credits directly reduce the amount of taxes owed, while tax deductions reduce the taxable income upon which the tax liability is calculated. Tax credits provide a more significant reduction in taxes than deductions because they offer a dollar-for-dollar reduction in the tax bill.