How a Tax Deduction Works
A tax deduction lessens the amount of income subject to tax. It does not reduce the amount of tax owed. Therefore the actual savings one gets varies with the different income tax brackets.
Consider the following example:
- If you claim a $200 deduction and you are in the 22% tax bracket, you save 22% of $200, which is $44.
- If however you are in the 12% bracket, the same deduction saves you only $24.
Although, a taxpayer will always benefit more in the higher brackets, in all cases, even at the lower $200 will never be $200 tax.
How a Tax Credit Works
A tax credit lowers your tax liability to the government by a certain amount. It happens to each and every one of us, regardless of taxable income, tax slab and financier tax classifications.
For example: should the tax obligations be remitted amounting to a thousand, and one qualifies for a credit of two hundred, his obligations now only amount to a credit of two hundred.
Unlike a deduction, the full amount of the credit always applies. Whether you are in the 12% bracket or the 37% bracket, a 200 dollar credit translates to $200 tax savings.
The Math Behind the Difference
Let’s compare side by side:
- $200 deduction at 22% tax rate: $44 saved.
- $200 credit: $200 saved.
The difference is clear. Tax credits are far more valuable than tax deductions or other relief you pay in taxes.
Why This Matters for Tax Planning
Understanding the distinction helps you plan and consequently put you in the best possible scenario. But while deductions, such as mortgage interest, incurred by the self employed, and certain medical expenses, can add up, credits while deductions can vary by each taxpayer, are more concentrated.
Some tax credits that one can avail are:
- Child Tax Credit
- Earned Income Tax Credit (EITC)
- American Opportunity Tax Credit (for education spending)
If applicable, these credits can lower your tax obligation significantly, or in some cases, completely.
The Bottom Line
A tax credit of $200 will always outweigh a $200 tax deduction. In fact, it outperforms any deduction of the same amount, no matter your income bracket. Taxes owed are reduced by a credit, making the tax system refund one of the most effective ways to lower your taxes owed.
Make the most of every tax dollar. Reach out to Dimov NYC CPA today to discover how smart credits and deductions can maximize your tax savings.
