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  • Margaret Schopp

All Things Are Not Created Equal


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!!

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