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Tax Deduction vs. Tax Credit

 
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Category : > Income Tax Filing Across The USA
Posted On : Thu Apr 22nd,2010

 
A tax deduction or a tax-deductible expense affects a taxpayer's income tax. A tax deduction represents an expense incurred by a taxpayer. They are variable amounts that you can subtract, or deduct, from your gross income.A tax credit is a similar concept, but is different in that it reduces the tax owed, rather than reducing taxable income. This amount of tax savings is not dependent on the rate the taxpayer pays.
 
Tax Deduction:
 
A tax deduction or a tax-deductible expense affects a taxpayer's income tax. A tax deduction represents an expense incurred by a taxpayer. They are variable amounts that you can subtract, or deduct, from your gross income. It is subtracted from gross income when the taxpayer computes his or her income taxes. As a result, the tax deduction will lower overall taxable income and thus lower the amount of tax paid. The exact amount of tax savings is dependent on the tax rate and can be complicated to determine. For some higher-income taxpayers, claiming all eligible tax deductions would result in having to pay the alternative minimum tax, and would result in a higher amount of tax paid.Tax deductions reduce how much you owe in taxes by decreasing your income. This can put you down into a lower tax bracket, and that means that you will owe less in terms of taxes. There are two types of tax deductions that lower your income.
  1. Figuring adjusted gross income. This type of tax deduction comes before you             figure out your tax bracket. This is all that stuff that fills in on the front of your Form xxx to get from the number on your earned income down to your adjusted gross income.
  2. Deductions from your adjusted gross income. When you flip your Form 1040 over, the first space is for your adjusted gross income. You then begin taking more deductions from there. You either take itemized deductions (Schedule A) or the standard deduction (which depends on your filing status -- married, single, etc.). You also get the dependent deduction and other deductions at this point.
     
  •  A tax deduction reduces income subject to tax.
  •  For each dollar of tax deduction, the reduction in tax liability is less than a dollar.
 Tax Credit:

A tax credit is a similar concept, but is different in that it reduces the tax owed, rather than reducing taxable income. This amount of tax savings is not dependent on the rate the taxpayer pays. Next is the tax credit. Tax credits are figured after you determine your tax bracket, and how much you should owe in taxes. A tax credit is a dollar for dollar reductions in the amount of tax you owe. You figure out how much tax you owe, and then the credits work as if you are applying a gift card for a certain amount to reduce how much you need to pay.
  •   A tax credit is a dollar-for-dollar reduction in the tax liability.
  •  For each dollar of tax credit, there is a dollar reduction in the tax liability.

1.   Deductions vs. Credits

As we all know, deductions and credits are two very important ways to reduce your overall tax liability. Every April, we scramble to find more and more deductions and credits so that we can pay the Tax Man less and less. But which one is best? Which is more advantageous? Which one saves you the most money?
 
The simple answer is that neither one is best; they are simply two different methods that the IRS gives to reduce the amount of tax you owe. How each impacts you depend, of course, upon your own unique tax situation. You may be eligible to take a certain deduction but not qualify for a particular tax credit. The thing to focus on is awareness of what you can legally claim. This takes knowledge, about your own circumstances as well as what the Tax Code makes available to you. Or, at least, the knowledge of the phone number of a competent tax lawyer or accountant. First, however, we need to get a clear view of what the two terms mean and how they differ.
 
Deductions:
 
Let’s start with deductions. A deduction is an expense or an amount of money which lowers your taxable income. It is subtracted "off-the-top" from the amount of money you made throughout the year, your gross income. Once all deductions are subtracted, this amount is known as your adjusted gross income, or AGI. Examples of deductions include contributions to a traditional IRA, student loan interest that was paid during the year, tuition and expenses, alimony paid, and classroom-related costs for teachers. There are also deductions that are related to self-employment income. The standard or itemized deductions are subtracted from the AGI, yielding your taxable income. This is the number which determines the amount of tax that you owe.
 
Credit:
 
Tax credits, on the other hand, are dollar-for-dollar reductions which are subtracted from your tax liability. Let’s say, for instance, that you qualify for a $xxx tax credit. The government is, in essence, saying to you “We are giving you credit for having already paid $xxx in tax." Therefore, $xxx is subtracted directly from the amount of tax that you owe.
 
There are tax credits for college expenses, for retirement savings, even for adopting children. Some well-known tax credits include the Hope and Lifetime Learning education credits, the Earned Income Credit, and the Child Tax Credit. There is many more special-interest and business or investment credits as well.
 
Tax credits can be more valuable than deductions, although somewhat more difficult to qualify for. Let’s assume, for example, that you owe $xxx in tax. For the purposes of this illustration, you are eligible for either a xxx tax deduction or a $xxx tax credit. Which would you choose? Well, the deduction, when subtracted from your gross income to get your taxable income, will only decrease the tax you owe by about $10. The tax credit would be subtracted directly from the tax you owe, which would mean that you owe no tax at all.
The best strategy when figuring your tax bill is to gather all of the information that you can about which credits and deductions you may be eligible for. Maximize both. And don’t overlook any state-specific deductions and credits where you live. Begin preparing for next year’s tax season now, and you’ll be able to keep more of your money in your own pocket, legally.
 
2. Tax Deduction vs. Tax Credit
 
Different countries have different tax laws and have different rate of ‘tax deduction’ and different rules for  ‘tax credit’ that reduces total annual tax payable, by the amount of ‘tax credit’ a person is eligible for. Tax deduction in effect reduces your total income whereas tax credit reduces your total tax burden. So we can differentiate between the two in many ways some of which are described below.
1. Tax deduction is done in a number of ways like tax deduction at source by way of deducting tax, prior to payment of salary, payment of winnings from lottery, gambling payment or payment to a contractor for his services etc. So the tax is essentially deducted by payment authority, which is paying you. A case in example is your employer. Tax credit is allowed only by the state through its income tax department as per income tax law of the concerned country.
2. Tax deducted from your income automatically turns into a part of overall tax credit at your hands, which you are eligible to adjust as deduction from the total amount of tax payable in a particular financial year while submitting annual returns.
3. Taxes are deducted at various rates depending on income slabs, payment amount etc whereas tax credits are fixed amounts.
4. All the taxes deducted become tax credit at your hands while all the tax credits are not income deductible. For example if you donate a sizable amount to charity organizations which do not have profit motive, then a percentage of such donation may be claimed as tax credit in tax returns. So is the case with home loan interest, educational loans or expenditures etc.
5. Tax credit received as a consequence of lowering your annual gross total income for donations made, certain interests paid and even certain expenditures made, in effect increases your income by refunding you the amount of tax credit you get from such lowering of gross total income. This is a sort of state benefit you get back through the tax refund system of the state.
6. in most countries self employed professionals, businessmen have to pay advance taxes depending on their projected annual income. Once such advance tax is deposited with the treasury, the amount automatically becomes a tax credit at the hands of the individual making such payment.
7. Whereas tax deduction is not refundable, tax credit may become refundable. For example a bank deducts tax on interest payment made to an individual on his deposits and hands him over the tax credit certificate. If the individual does not have taxable income or his total tax payable is less than the tax credit, then he gets full or a part of the tax credit as refund, in effect increasing his total income.
 
 
 How much income tax you have to pay is determined by your income. To pay the least amount of taxes, you want to take applicable tax deductions to reduce your taxable income and tax credits to reduce your tax bill.
 
Tax Credits
Tax credits are typically given for educational purposes, low income or having dependents. The amount of the credit is deducted from your tax liability and produces a significantly higher bottom-line reduction than a deduction.
 
Tax Deductions
Tax deductions reduce your taxable income, which is the amount the government uses to determine how much tax you should pay. Some deductions can be taken only if you itemize.
 
Qualifying for tax credits and deductions
It is important to note that not everyone qualifies for certain tax deductions and credits. If you make more than a certain amount of money, some credits and deductions, such as for savings accounts, Earned Income Credit and other tax lowering credits and deductions, are not available to you. There are worksheets available to help you determine whether or not you can take a certain tax credit or tax deduction.
 
 Refundable VS Non-refundable Credits

Refundable credits are credits that can be taken in full, even if they exceed the amount that you owe the government. The Earned Income Credit is one example. Non-refundable credits are credits that cannot reduce your tax liability beyond zero. If a non-refundable credit is more than what you owe in taxes, you can only take up to the amount owed.
Common Deductions
Some common deductions that you can take without having to itemize are deductions for retirement contributions, student loan interest, capitol losses and business expenses.
 
Common Tax Credits
The Child Tax Credit, Adoption Credit, Child and Dependent Care Credit, First-Time Homebuyer Credit and The Hope or Lifetime Learning credit are common tax credits, foreign income credit etc.

Conclusion
 
1) Tax deduction is that part of taxes which are already paid as tax deducted at source or deposited as advance tax. Tax credit is the tax already deposited with the state treasury plus state benefit to its citizen paid back through its tax assessment system.

2) Tax deduction lowers the income; the tax credit lowers the tax burden

3) Taxes are deducted at various rates depending on income slabs, payment amount etc whereas tax credits are fixed amounts.
 

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