Quickbooks, Bookkeeping and Accounting Blog

I am often asked about the difference between tax credits and tax deductions. The difference is very significant. Definitions of both terms follow:

• Tax Credit: tax credits are dollar for dollar reductions of the total amount you owe the IRS.
• Tax Deductions: tax deductions reduce your gross income, allowing you to obtain your adjusted gross income, which is used to calculate your tax liability.

Depending on your tax rate, a tax credit can be worth 2 to 5 or more times a tax deduction. Consider the following example:

Suppose you earned $75,000 last year and had $20,000 in deductions (for state and local taxes paid, mortgage interest, charitable gifts, etc.), resulting in $55,000 in taxable income. Then suppose that this results in taxes due of $7,500 (actually depends on your individual circumstances - single, married filing jointly, etc.). Now, let’s suppose first that you discovered an additional $1,000 deduction and that you discovered an additional $1,000 tax credit.

• Additional $1,000 tax deduction: this would reduce your taxable income to $54,000 and the taxes you owe to about $7,300. Therefore, this $1,000 deduction reduced the amount you owe the IRS by $200.
• additional $1,000 tax credit: since the credit comes directly off the amount you owe the IRS, it reduces the amount you owe the IRS from $7,500 to $6,500.

 As is obvious from the above example, the difference between tax credits and tax deductions is very significant.