What is the difference between a tax credit and a tax deduction?
A tax credit is a dollar-for-dollar reduction in what the taxpayer owes. That means that a taxpayer who owes $7,500 in income taxes and who receives a $7,500 tax credit would owe nothing to the IRS. A tax deduction is subtracted from the amount of income that is taxed. Using the same example, assume the taxpayer is in the 15 percent tax bracket and owes $7,500 in income taxes. If the taxpayer receives a $7,500 deduction, the taxpayer’s tax liability would be reduced by $1,125 (15 percent of $7,500), or lowered from $7,500 to $6,375.
A tax credit is a dollar-for-dollar reduction in what the taxpayer owes. That means that a taxpayer who owes $7,500 in income taxes and who receives a $7,500 tax credit would owe nothing to the IRS. A tax deduction is subtracted from the amount of income that is taxed. Using the same example, assume the taxpayer is in the 15 percent tax bracket and owes $7,500 in income taxes. If the taxpayer receives a $7,500 deduction, the taxpayer’s tax liability would be reduced by $1,125 (15 percent of $7,500), or lowered from $7,500 to $6,375.
It’s important to understand the distinctions between a tax credit and a tax deduction, since they are two different ways of reducing the total taxes you will pay. When you first start deciding how much you will pay in taxes, you are allowed certain deductions, like those for each child or dependent. These deductions reduce the amount of your income that is considered taxable. Conversely, the tax credit is taken after you have decided what portion of your income is taxable and have figured out how much tax you actually must pay. When you can take certain tax credits, perhaps like those offered for purchasing a hybrid vehicle, you deduct this amount directly from the taxes you owe. If you owe $2500 US Dollars in taxes and you have a $2000 USD tax credit, you subtract that credit directly from $2500 USD, reducing total taxes owed to $500 USD. The amount of taxes that you have paid over the year is also part of your tax credit. This amount is deducted from the total you may still owe, or
