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What's the difference between a tax credit and a tax deduction?

Mar 20, 2012 by Alden from Ballwin, MO in  |  Flag
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A tax deduction is an amount that reduces your taxable income, whereas a tax credit reduces your amount of tax owed.

To illustrate, assume that you make $50,000 and are in a 20% tax bracket. A $2,000 deduction would reduce your taxable income to $48,000, and you would owe $9,600 in tax. A $2,000 tax credit would reduce your tax bill dollar for dollar, so your tax would be $8,000 ($50k x 20% less $2,000). In the real world, there are phase-outs, exclusions, and other provisions that can make it extremely difficult to calculate the true value of a credit or a deduction, unless you have tax software or are working with a qualified tax preparer who has tax software.

Comment   |  Flag   |  Mar 20, 2012 from San Francisco, CA

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A tax deduction is an expense or an amount of money which lowers your taxable income. It is subtracted "off-the-top" from the amount of money you made throughout the year, your gross income. Once all deductions are subtracted, this amount is known as your adjusted gross income, or AGI. The standard or itemized deductions are subtracted from the AGI, yielding your taxable income. This is the number which determines the amount of tax that you owe. A tax deduction is something that reduces the overall amount of taxable income you have and will reduce the amount you have to pay.

Tax credits, on the other hand, are dollar-for-dollar reductions which are subtracted from your tax liability. Let’s say, for instance, that you qualify for a $100 tax credit. The government is, in essence, saying to you “We are giving you credit for having already paid $100 in tax." Therefore, $100 is subtracted directly from the amount of tax that you owe. A tax credit will put money in your pocket. This type of incentive will reduce the amount of tax owed by an individual to the federal government.

The best strategy when figuring your tax bill is to gather all of the information that you can about which credits and deductions you may be eligible for. Maximize both. And don’t overlook any state-specific deductions and credits where you live.

The best advice is for any individual to talk to a CPA or professional tax preparer to make sure that you qualify.

Comment   |  Flag   |  Mar 20, 2012 from Lititz, PA

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