Tax Credit vs. Tax Deduction

When attempting to lower taxes, individuals and businesses have two options, tax credits and tax deductions. Both can lower the total amount of tax due, but both have different mechanisms and requirements.

A tax credit reduces taxes owed by a certain amount. If total taxes owed are $10,000, and the taxpayer has a $1,000 tax credit, the resulting taxes owed are $9,000. Tax credits can be refundable or nonrefundable, with refundable credits allowing the taxpayer a cash refund, and nonrefundable credits allowing no cash refund.

Tax credits for individuals include earned income credits, for taxpayers with low-income, as well as childcare credits, for those taxpayers who must pay childcare expenses in order to maintain employment. There are also tax credits available for the elderly and the disabled, as well as credits for contributions to qualified retirement plans, such as Individual Retirement Accounts (IRA).

Tax credits for businesses include credits for the hiring of at-risk individuals, as well as credits for environmental factors, such as the use of alternative fuels.

Tax deductions do not directly lower taxes owed, but they indirectly lower taxes by reducing taxable income. There are numerous types of tax deductions a business or individual can be eligible for, such as mortgage interest, medical expenses, and charitable deductions.

For example, someone with an income of $100,000, with deductions of $10,000, will have an adjusted taxable income of $90,000. With a tax rate of 30%, the taxpayer would owe $27,000, versus the $30,000 the taxpayer would owe without the deduction.

Generally speaking, a tax credit is more valuable than a tax deduction. If a taxpayer is in the 30% bracket, a $10,000 deduction will result in a tax bill lowered by $3,000. However, a tax credit of $10,000 lowers the tax bill by $10,000, regardless of the taxpayers tax bracket.