What is the difference between a deduction and a credit? The definition is simple, but the explanation is not.

Definition:
A deduction reduces your taxable income
A credit reduces your tax

Explanation of a Deduction:

In calculating taxable income, the Internal Revenue Service allows certain reductions in the amount of income to which the relevant tax rate is applied. Some of these include:

  1/2 of self employment tax for proprietors
  IRA contributions up to the current limit
  Standard or Itemized deductions for Medical, Interest, Taxes, Charitable Contributions, Unreimbursed Employee Expenses, Contributions, etc.
  Personal Exemptions are a form of deduction as well.

These deductions are subtracted from the Gross Income to arrive at the Taxable Income (TI) of the taxpayer. Therefore, any Deduction saves the taxpayer money only based on his tax rate.

For example:
Let’s say that John has $40,000 in gross income, $11,000 in itemized deductions and three exemptions at $3,650 each. His Taxable Income (TI) is $18,050. At this net amount, his tax rate would be 10% so his tax would be $1,805

$ 40,000 Gross Income
( 11,000) Itemized Deductions
( 10,950) Personal Exemptions (3,650 x 2)
————–
$ 18,050 Taxable Income
x .10 Tax Rate
————-
$ 1,805 Tax Due

The tax amount the deductions saved him is $2,195 or 10% of the total deductions $21,950.

Explanation of a Tax Credit:

A credit is used to determine, finally, how much tax must be paid or how much of a refund the taxpayer will receive. There are many types of credits, but the most common are:

  Child Care Credit for day-care or after-school care if both parents work
  Elderly Credit for elderly earning below a certain level
  Earned Income Credit which is a refund of a portion of the taxpayers Social Security Tax for certain low-income individuals

Any amounts actually withheld from wages or salaries are fully credited against taxes due as are payments made by the taxpayers either from a prior year refund or directly as estimated tax deposits.

A Tax Credit reduces the actual tax due, dollar for dollar.

So, given the scenario above, if John had $500 withheld from his pay over the year, the tax rules allow $2,000 as a child tax credit and let’s say he get’s $400 in Child Care Credit. His tax would look like this:

$1,805 Total Tax
(  400) Child Care Credit
(1,405) Child Care Credit
——————–
$     0 Total Tax Due
(  500) Federal Tax Withheld on Form W-2
(  595) Refundable Child Tax Credit
——————–
$1,095 Tax Refund

Summary

A credit is better than a deduction, but deductions can add up to significant tax savings as well. So, save those medical receipts, track your business mileage, and make sure you get documentation on all of your charitable donations.