Every industry and profession has common terms that are used so often those of us in the business often forget that most people do not have the depth of understanding that a person working within the tax code might have. One of these areas is understanding the differences between the tax terms “deductions” and “credits”. Is one better than the other?
If it were simple
Dollar for dollar, a credit is worth more to you than a deduction. Why? A credit is a direct reduction in tax, while a deduction reduces the amount of income that gets taxed. Here is a simple chart showing the difference.
Assuming you have a $2,000 tax credit, how large a deduction would you need to be indifferent?
|Your marginal tax rate||Deduction required to equal $2,000 tax credit|
Note: This example does not account for the possibility that the deduction could move you into a lower tax rate nor does it consider other tax factors, including phaseouts.
So on the surface it appears that a credit is worth more than a deduction to you. But the real answer is….it all depends. Here are some things to consider:
How much is it? A large deduction could be worth more to you than a small credit. In combination with your marginal tax rate, you can calculate the equivalent credit that equals your deduction.
Your marginal tax rate. Remember, a similar deduction is worth more to someone in the 35% income tax range than it is to someone being taxed at 10%.
Are there phase-outs? Most credits and deductions phase out when your income is over certain amounts. Consider this when determining the true tax benefit. When a deduction reduces your income it could make other credits and deductions that were previously phased out now available to you.
Is the credit refundable? Some credits get a “bonus”. While you cannot deduct your income below zero, you can sometimes receive credits that create a refund even if you owe no tax. Credits that have this “bonus” feature are called “refundable” credits.
When it matters
Educational Expenses. If you pay tax-deductible tuition for undergraduate studies you must decide what tax alternative is best for you. Among the many alternatives that need to be evaluated are the American Opportunity Credit, the Lifetime Learning Credit, and the Tuition Deduction.
Understanding the Cost. Remember the value of a deduction to you needs to be filtered with your marginal tax rate to see the true tax benefit. Here is a simple formula.
|Deduction Amount||x||Your Tax Rate||=||Your Tax Benefit|
Thankfully, professional tax software allows for quick analysis of the choices. Please call if you have questions.