The key difference between a deduction and a credit is how they reduce your tax burden. A tax deduction lowers your taxable income, which indirectly reduces the amount of tax you owe based on your tax rate. In contrast, a tax credit directly reduces the actual tax amount you owe, dollar for dollar, making it more valuable because it directly decreases your tax bill.
Further Explanation
- Tax Deduction : Reduces taxable income. For example, a $1,000 deduction in a 20% tax bracket saves $200 in taxes.
- Tax Credit : Directly reduces tax liability. For example, a $1,000 tax credit reduces your tax owed by $1,000, regardless of tax bracket.
Practical Impact
- Credits usually provide a bigger savings than an equivalent deduction.
- Deductions are beneficial especially to those in higher tax brackets since they reduce income on which tax is calculated.
- Some credits are refundable, meaning they can increase your refund if they exceed the tax owed.
This distinction is crucial in understanding tax planning and how different benefits affect tax bills and refunds.