Tax credit or tax deduction? Do you know the difference?
I decided to pick this issue because at MBPC, we talk a lot about the Earned Income Tax Credit (EITC) and how it is one of the most effective ways to help working, low-income families. Don’t worry, the EITC will be explained in a future post - one step at a time, folks.
Every year when we do our taxes, people have to decide if they will use the standard deduction or the itemized deduction, which includes home mortgage interest and charity donations. Then we also have to factor in our tax credits. But do you know what’s what?
Here’s a quick comparison of what a tax deduction is versus what a tax credit is.
Tax deductions reduce your taxable income, that is, the amount of income the government will use to calculate your income taxes. One example is the charity deduction. Let’s say you make a $1,000 donation to a worthwhile charity, say the Montana Budget and Policy Center (hint, hint). This deduction reduces your taxable income by $1,000. The amount of actual tax savings will depend on what tax bracket you are in. If you are in a 15% tax bracket, a $1,000 tax deduction will save you $150 in taxes. If you are in a 40% tax bracket, this same $1,000 tax deduction will save you $400 in taxes.
On the other hand, tax credits are applied directly to your tax liability – in other words – what you owe. So if you have a tax credit like adopting a child, buying a first home, or home office expenses, those reduce your tax bill, dollar for dollar. For example, if you qualify for the full child tax credit of $1,000, you will save $1,000 in taxes.
A tax credit has a bigger impact on your tax liability than a tax deduction of the same amount.
But wait, there is more.
Since this is a Wonky Word post, I thought I would wonk out (yes I am using it as a verb) on this a bit more.
Did you know that a child can be a tax credit and a tax deduction? If your income is low enough to qualify you for the Child Tax Credit – your new bundle of joy is a credit. If it does not, then you can still claim little Bobby or Sally as a dependent, which is a tax deduction!
Also, some tax credits are refundable. That means if the amount of taxes you owe is less than the credit, you will get a refund. As I mentioned earlier, the Earned Income Tax Credit is an example of a refundable tax credit. But we’ll save that for another week.
Wow, I could go on and on. Thanks for checking into this week’s Wonky Word Wednesday. Tax credits and deductions impact all of us. I’m glad we all know the difference now.
I hope you will check back each Wednesday for more wonky words. If you have suggestions, email me at firstname.lastname@example.org or post something to our Facebook page.
MBPC is a nonprofit organization focused on providing credible and timely research and analysis on budget, tax, and economic issues that impact low- and moderate-income Montana families.