One of the most fundamental items you need to know to have even a basic understanding of taxation is the difference between a tax credit and a tax deduction. You’ll hear these two items discussed quite frequently, but we’re struck by how often people mix them up or use them interchangeably when they are dramatically different.
A tax credit is a dollar-for-dollar reduction of your tax liability (another item of terminology: you tax liability is the total tax amount owed on your tax return). A $1 dollar tax credit is worth the same as $1 dollar in cash. So if you owe $1,000 with your return and you have a $1,000 tax credit, that covers the entire liability and you don’t have to send the IRS a check for anything.
A tax deduction is worth only a fraction of what a tax credit is worth. A $1 dollar tax deduction reduces the amount of income you’ll be taxed on by $1 dollar. This deduction occurs before the tax rate is applied, so depending on your marginal tax bracket (tax rate), a $1 tax deduction could be worth maybe 25 cents.
A tax deduction that most people are aware of is the mortgage interest deduction. So let’s say you earn $70,000 and you have $15,000 of deductions, your taxable income subject to the tax rate in this example would be $55,000. The tax rate is then applied against the $55k and that gets you to your tax liability.
When people talk about “writing something off” on their taxes, they really mean they are going to take it as a deduction.
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