In the infinitely fun and exhilarating world of tax, it’s easy to get caught up in the thrill of it all and lose sight of the details (yes, we’re being facetious). But in all seriousness, many people do lose sight of the details, and the details really do matter.
Details are especially important when it comes to terms and definitions. Two tax terms in particular that people often use interchangeably (and incorrectly) are deduction and credit. Let’s take a look at the differences:
- Tax credit: A tax credit reduces your tax liability.
- Tax deduction: A tax deduction reduces your level of taxable income.
So what’s the difference? Let’s look at an example. Billy and Janet both make $45,000 per year in taxable income, and to start, both have $2,500 in tax liability. Billy is eligible for a $1,000 credit, and Janet is eligible for a $1,000 deduction.
- Billy received a $1,000 tax credit for having a child under the age of 17. That $1,000 tax credit is, dollar-for-dollar, directly reduced from the $2,500 in tax liability, thus lowering it to $1,500.
- Janet received a $1,000 tax deduction for making a charitable donation. The deduction reduces her taxable income by $1,000, thus lowering it from $45,000 to $44,000. This will still ultimately lower her tax liability — but probably more to the tune of $250.
In the end, both deductions and credits are great. It means more money in your pocket and less for the IRS. But back to the hypothetical question … a $1,000 tax credit or a $1,000 tax deduction, which is worth more? While you may be able to identify a few instances where the deduction make more sense because of a change in tax bracket, the credit will be worth more the vast majority of the time.