Finances & Money

Tax Deductions vs Tax Credits

There are two categories of people during the beginning months of the year; those that have already done their taxes, and those that are about to do their taxes. Part of the process is looking for ways to reduce your tax bill. Two major categories of ways to reduce what you owe the government are tax deductions and tax credits. While they sound similar, and they both reduce the amount you must pay, there is a significant difference between tax deductions vs tax credits.

Tax Deductions

A tax deduction reduces your taxable income. For example, if your income during a year is $80,000 but you have $5,000 in deductions then the income you will be taxed on is $75,000. The reduction in the amount of taxes owed will be a percentage of the deduction.

Here’s how it works:

If your effective tax rate is 20% with $80,000 in taxable income, your tax bill would be $16,000.  After the tax deduction, with an effective tax rate of 20% and $75,000 in taxable income, your tax bill would now be $15,000.

Your tax deduction of $5000 results in your tax bill being reduced by $1000.

Examples of tax deductions:

• Student Loan Interest: interest paid on student loans
• Mortgage Interest: interest paid on a primary home mortgage
• Charitable Donations: donations made to charitable organizations

Tax Credits

A tax credit directly reduces your tax bill by the amount of the credit. We’ll use the same example of $80,000 of taxable income and the same effective tax rate. But instead of a tax deduction, let’s say it’s a $5000 tax credit.

Here’s how it works:

With an effective tax rate of 20%, the initial tax bill is again $16,000. But with the tax credit, you subtract the entire amount of the credit. Your $16,000 tax bill is now $11,000.

Your tax credit of $5000 results in your tax bill being reduced by $5000.

Examples of tax credits:

• The American Opportunity Tax Credit: Cost of higher education
• The Child And Dependent Care Credit: Expenses paid for the care of qualified children

The tax code provides many ways to reduce your tax bill. Knowing what they are, and the different way they can affect your overall taxes owed will help you file an accurate return in which you do not overpay your fair share to the government.