Difference Between Tax Credit vs Tax Deduction
“The income tax created more criminals than any other single act of government.”
– Barry Goldwater
Income tax is a crucial part of human civilization. Paying taxes on time to the Government makes a good citizen and paying taxes by taking benefits makes a smart citizen. Tax evasion has been seen in every part of the world and in every era of human civilization. To avoid being criminalized one should be smart enough to understand taxes paid to Government. Tax credit vs tax deduction is an important topic in order to learn tax planning.
Every year millions of taxpayers’ search for tax deduction vs tax credits which can help them to save taxes. One should use Tax Credit vs Tax Deduction facilities provided by Government to save money. Don’t ignore the fact that Tax Credit vs Tax Deduction are separate things.
What is Tax Deduction?
A tax deduction is a result of a tax-deductible expense or exemption which reduces the taxable income of the taxpayer.
Common tax deduction on federal income tax return is a personal exemption.
How it is calculated – if your income was $ 1,00,000, and you have a personal exemption of $ 8,000. your personal exemption would reduce your taxable income by $ 8,000. So, your taxable income will be $ 92,000.
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Assesses can claim deductions on various expenses –
- Life insurance premiums
- Donations to institutes permitted by Government etc.
- Medical expenses for self and family
- Contribution to funds permitted by Government
- Charitable donations
- Mortgage loan interest
- Medical and dental expenses
- Tuition and fees
- Contributions to a traditional IRA
- Contributions to health savings accounts (HSAs)
- Mileage for business travel
- Unreimbursed business expenses
- Moving expenses to start a new job
- Job search expenses
- Teacher’s educational expenses
- Property and real estate taxes
Each country has a pre-defined basket of deductions. These deductions are decided by Government for benefits of its citizens. For example, In India, section 80C permits the deduction for tax savings.
What is a Tax Credit?
A tax credit is subtracted from tax liabilities. A common tax credit example is a child tax credit. If you have a qualifying child, you can avail tax credit up to $ 1,000.
How it is calculated – if your income was $ 1,00,000, and you have a personal exemption of $ 8,000. your personal exemption would reduce your taxable income by $ 8,000. So, your taxable income will be $92,000. Let’s assume 30% tax rate (ignoring tax slabs for understanding), so your tax liabilities will be $ 92,000 * 30 % = $ 27,600, now you can claim $1,000 as tax credit so your effective tax will be $ 27,600 – $ 1000 = $ 26,600
Some tax credits made available in India are:
- If income has been earned outside India and a tax paid on it in that country then a tax credit can be claimed in India for the tax that has been paid outside.
- Anyone who has an income less than Rs. 5 lakhs per annum but is liable to pay taxes can claim a tax credit of Rs. 2,000.
- Citizens who are above the age of 65 years can avail a tax credit of up to Rs. 20,000,
Some other tax credit available outside India –
- Even those with disabilities, falling under a particular income bracket can receive tax credits.
- Child and Dependent Care Credit (to reduce the cost of childcare or taking care of an old parent)
- Adoption Credit (for adoption expenses)
- Child Tax Credit (for parents)
- Premium Tax Credit (for people who purchased health insurance through the federal marketplace)
- Saver’s Credit (for people who contributed to a tax-advantaged retirement account)
- Lifetime Learning Credit (for higher education expenses incurred)
Each country has pre-defined guidelines for tax credit and basket of a predefined basket of tax credit items.
Tax Credit vs Tax Deduction Infographics
Below are the top 5 difference between Tax Credit vs Tax Deduction.
Tax Credit vs Tax Deductions – Exceptions
Even though you can save tax by using Tax Credit vs Tax Deduction facilities provided by the government, there can be a break in tax savings as almost every item has a maximum limit on tax saving. However, by studying exceptions, you can claim tax credits & tax deduction. This is the point where tax planning becomes somewhat complicated.
As an example, imagine this scenario:
- Your filing status is married filing jointly, with two dependent children under age 18
- You earned $55,000, all from your jobs
- Your tax liability, before figuring allowable credits, is $1,500
- Your two children allow for a Child Tax Credit of $2,000 ($1,000 each)
- But the child credit is limited to your tax liability because it’s non-refundable, in this case, $1,500
- Normally, you’d have to forfeit the remaining $500 and would not receive a $500 refund
However, the exception to the rule allows you to slide the forfeited $500 over to the Additional Child Tax Credit, which means you just have to do some math to get yourself a nice refund. The Additional Child Tax Credit lets you claim the lesser of two amounts: the amount you might have to forfeit (in this case $500) or 15% of your earned income greater than $3,000.
That’s where the tax code gets complicated again, so take a look at the calculation: 15% of your earned income in excess of $3,000 is $7,800 ($55,000 – $3,000 = $52,000; $52,000 * 15% = $7,800). Since $500 is less than $7,800, that’s the amount you’re allowed to take. Thus, instead of forfeiting the credit, you now have an extra $500 refund.
Head To Head Comparison between Tax Deduction vs Tax Credit
Let us examine some of the difference between Tax Credit and Tax Deduction:
|
The Basis Of Comparison Between Tax Credit vs Tax Deduction |
Tax Deduction | Tax Credit |
| Meaning | These are deductions which help in reducing the overall taxable income | It is a tax incentive whereby the taxpayer is able to deduct the amount of tax |
| Reduction in | Helps in reducing taxable income | It is an obligation in payment of taxes |
| Point of adjustments | Adjusted before application of the tax rate. | Adjusted after-tax due is ascertained |
|
Tax saving |
It reduces tax by a marginal percentage | The tax deduction is applicable on a dollar to dollar basis. |
|
Occurrence |
Due to the various expenses incurred by the taxpayer |
Due to tax already deposited with taxation authorities or due to certain circumstances. |
Conclusion
Both the tax credits vs tax deductions help in reducing the overall tax burden on taxpayers and also help them save the tax. However, a tax credit is more favorable than tax deductions, as the former lowers the tax liabilities directly so saves more tax whereas the latter only reduces the tax liabilities by nominal rate.
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