THE CREDIT vs. THE TAX DEDUCTION
A client called up earlier this morning with a great question - what is the difference between a tax credit and a tax deduction?
Let me answer that question with an example. For both examples, I am going to say that a tax credit is $5,000 and a tax deduction is $5,000. Okay, here goes:
Example 1 - TAX CREDIT:
Income $100,000
LESS: Income tax deduction $0
Taxable Income $100,000
Income tax (assuming a tax rate of 28%) $28,000
TAX CREDIT $5,000
Amount you pay the IRS $23,000
In this example, the credit is applied against the income tax.
Example 2 - TAX DEDUCTION:
Income $100,000
Tax deduction $5,000
Taxable Income $95,000
Income tax (assuming a tax rate of 28%) $26,600
TAX CREDIT $0
Amount you pay the IRS $26,600
In this example, the deduction is applied to the taxable income and then the income tax is computed.
So, to summarize:
$5,000 tax credit = $23,000 in tax
$5,000 tax deduction = $26,600 in tax
So, now you get the concept of a tax credit versus a tax deduction. To make this even more interesting, let's add one more layer. Tax credits come in two flavors:
- refundable
- non-refundable
Again, instead of trying to explain in words, I am going to give an example. Let's go back to the tax credit example but with a slight tweak. Instead of income of $100,000, what if income was $15,000; all other numbers stay the same.
Example 3 - NON-REFUNDABLE TAX CREDIT:
Income $15,000
Income tax deduction $0
Taxable Income $15,000
Income tax (assuming a tax rate of 28%) ** $4,800
TAX CREDIT $5,000
Amount you pay the IRS $0
In this example, the taxpayer DOES NOT get a refund, because the tax credit is not refundable.
Example 4 - REFUNDABLE TAX CREDIT:
Income $15,000
Income tax deduction $0
Taxable Income $15,000
Income tax (assuming a tax rate of 28%)** $4,800
TAX CREDIT $5,000
REFUND from the IRS $200
So, in order of financial benefit from lowest to highest:
1. Tax deduction (example 2)
2. Tax credit (example 1 and 3)
3. The holy grail: REFUNDABLE Tax Credit (example 4)
Hope that helps.
** Yes, I know that the tax rate on $20,000 is not 28%, but I am trying to demonstrate a point here, so go with it!!