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

Tax Credit vs. Tax Deduction

Tax Credit:

- A tax credit directly reduces the amount of tax owed, dollar for dollar.

- It is subtracted from the total tax liability, not the taxable income.

- Tax credits can be refundable or non-refundable:

 - Refundable tax credits can result in a refund if they exceed the taxpayer's liability.

 - Non-refundable tax credits can only reduce the tax liability to zero and not result in a refund.

Tax Deduction:

- A tax deduction lowers the amount of income subject to tax.

- It is subtracted from the taxpayer's gross income, thus reducing the taxable income.

- The value of a tax deduction depends on the taxpayer's marginal tax rate.

- There are two types of deductions:

 - Standard deduction: A fixed dollar amount that varies by filing status and is adjusted annually for inflation.

 - Itemized deductions: Specific expenses that taxpayers can choose to list separately. Itemizing is beneficial when total itemized deductions exceed the standard deduction.

Impact on Tax Liability:

- Tax credits generally offer a dollar-for-dollar reduction in tax liability, potentially making them more valuable than deductions.

- Tax deductions reduce the taxable income, and their value is tied to the taxpayer's tax bracket.

Examples of Tax Credits:

- Earned Income Credit (EITC)

- Child Tax Credit

- Clean Energy and Vehicle Credits

Examples of Tax Deductions:

- Certain medical and dental expenses

- State and local taxes

- Mortgage interest

- Charitable contributions

In summary, while both tax credits and tax deductions reduce overall tax liability, they do so in different ways. Credits reduce the tax owed directly, while deductions lower the taxable income. Taxpayers should consider their individual circumstances and the nature of the tax benefit to determine which provides the greater tax advantage.

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Sources:

Publication 225 (2023), Farmer's Tax Guide | Internal Revenue Service 2024-07-30

Publication 1212 (01/2024), Guide to Original Issue Discount 2024-08-02

Publication 551 (12/2022), Basis of Assets | Internal Revenue Service 2024-07-30

Deductions for individuals: What they mean and the difference between 2024-08-04

Topic no. 409, Capital gains and losses | Internal Revenue Service 2024-08-04

Independent contractor (self-employed) or employee? 2024-08-03

Tax Expenditures | U.S. Department of the Treasury 2024-08-02

Fringe Benefit Guide | Internal Revenue Service 2024-08-03

for Education Benefits | Internal Revenue Service 2024-08-02

Instructions for Form 990 Return of Organization Exempt From Income Tax 2024-08-02