Every industry and profession has common terms that are used so often those of us in the business often forget that most people do not have the depth of understanding that a person working within the tax code might have. One of these areas is understanding the differences between the tax terms "deductions" and "credits". Is one better than the other?
Top line. Dollar for dollar, a credit is worth more to you than a deduction. Why? A credit is a direct reduction in tax, while a deduction reduces the amount of income that gets taxed. Here is a simple chart showing the difference.
Assuming you have a $2,000 tax credit, how large a deduction would you need to be indifferent?
|Your marginal tax rate||Deduction required to equal $2,000 tax credit|
Note: This example does not account for the possibility that the deduction could move you into a lower tax rate nor does it consider other tax factors.
So on the surface it appears that a credit is worth more than a deduction to you. But the real answer is….it all depends. Here are some things to consider:
Your marginal tax rate. A similar deduction is worth more to someone in the 35% tax range than it is to someone being taxed at 10%.
How much is it? A large deduction could be worth more to you than a small credit. In combination with your marginal tax rate, a deduction could be worth a lot more to you than a credit.
Are there phase-outs? Most credits and deductions phase out when your income is over certain amounts. You must consider this when determining the true tax benefit. Consider that a deduction that reduces your income could make other credits and deductions that were previously phased out now available to you.
Is the credit refundable? Some credits get a “bonus”. While you cannot deduct your income below zero, you can sometimes receive credits that create a refund even if you owe no tax. Credits that have this “bonus” feature are called “refundable” credits.
When does any of this matter?
Educational Expenses. A common area in which understanding credits and deductions is important is in the use of educational tax benefits. If you paid tax-deductible tuition for undergraduate studies you must decide what tax alternative is best for you. Among the many alternatives that need to be evaluated are the American Opportunity Credit and the Lifetime Learning Credit (Assuming all of these options remain available to taxpayers.).
Understanding the Cost. When proposals come through Washington, understanding the difference between credits and deductions can help you understand how the proposed changes impact your tax situation. Remember the value of a deduction to you needs to be filtered with your marginal tax rate to see the true tax benefit. Here is a simple formula.
|Deduction Amount||x||Your Tax Rate||=||Your Tax Benefit|
Included for your reference are some of the more common deductions and credits. Thankfully, professional tax software allows for quick analysis of the choices.
|Common Credits||Common Deductions|
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Note: Many of these credits and deductions are not a permanent part of the tax code. Some have been repeatedly extended while others have or will expire without congressional action.