What Are The Differences Between Tax Deductions And Tax Credits?


Balance Pro Staff

posted on

September 13, 2023

When we file our tax forms, we all try our best to claim as many tax deductions and credits as possible. They both enable us to pay less tax and put money back into our pocket, which is something that almost everyone appreciates.

But are you aware that tax deductions and tax credits bring about a reduction in our tax liability via entirely different mechanisms? In other words, tax deductions and tax credits aren't the same thing, although many individuals often are under the impression that they are.

The question now is, how can you differentiate between these two seemingly similar things?

What is a Tax Credit?

A tax credit will immediately reduce the amount of taxes you are responsible for. Saver's Credit, the Child and Dependent Care Credit, and the Residential Energy Credits are all examples of popular tax credits.

Thanks to your tax credit, it is easy to calculate how much money you would save. You do not need any calculations using the marginal tax rate. When you have satisfied all of the prerequisites for a particular tax credit, you may deduct the value of that tax credit straight from the taxes you owe.

Credits can reduce the amount of tax you owe or increase your tax refund. Certain credits may give you a refund even if you don't owe any tax.

Consider the following scenario: you owe $10,000 in back taxes for the current year. A tax credit of $3,000 will immediately and directly reduce your taxes by $3,000, bringing the total amount you owe the IRS down to $7,000.

What is a Tax Deduction?

If you itemize your business expenses (deductions), you may reduce the amount of taxable income and, consequently, the amount of tax you owe. To put it another way, you must first deduct certain expenses from your total income before figuring out how much tax you owe. The interest paid on student loans and payments made to retirement accounts and home offices are common tax deductions.

Deductions can reduce the amount of your income before you calculate the tax you owe.

Your marginal tax rate will determine how much money you may save via tax deductions. To calculate the potential reduction in your tax liability that a deduction could provide, you need to multiply the tax deduction by your highest marginal tax rate. For instance, if you have a deduction of $2,000 and you are in the tax bracket, that is, 22%, you will be able to reduce the amount of money you owe in taxes by $440. Therefore, the higher your tax bracket, the more value deductions will provide to you.

Which should you choose between a tax deduction and a tax credit?

In most cases, tax credits are more beneficial to you than tax deductions since they directly reduce your taxable income. However, whether you can claim a tax credit or even a deduction for the same costs, you need to perform the arithmetic to figure out which one would save you the most money.

You can file your taxes more quickly and properly if you know the differences between these two essential tax words, tax deductions and tax credits. You will also be able to avoid making errors that might cost you a lot of money.

You could believe that the tax nightmare is finally over after you have submitted your tax return. However, if you are subject to an audit, it is recommended that you preserve a copy of all tax receipts for up to seven years. Balance Pro is here to assist you if you are looking for a simple solution to this problem!

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This post is for informational uses only and is not legal, business, or tax advice. Please consult with an attorney, business advisor, or accountant with concepts and ideas referenced in this post. Balance Pro assumes no liability for actions taken in reliance upon the information contained in this article.

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