In the course of preparing tax returns over the last few years, I have heard people confuse the concepts of tax credits and tax deductions.
What’s worse is that I’ve even seen various financial writers and bloggers misuse the terms when performing various types of analysis involving taxes.
Let’s take a look at the difference.
A deduction is basically an expense that the IRS (really the tax code) allows you to “deduct” from your gross income. This will serve to lower your taxable income by the amount of the deduction.
For instance, if your gross income is $100,000 and you have no other adjustments, then you will be taxed on $100,000 (minus the standard deduction). Now add $10,000 in deductible charitable contributions (and no other adjustments), you will be taxed as if you only earned $90,000.
So, as you can see, having deductions can be pretty valuable because they reduce the amount of your taxable income.
For each taxpayer, the IRS applies a standard deduction. This is an amount that they automatically deduct from a taxpayer’s gross income.
However, if your deductions were more than the standard deduction, you have the option of claiming that higher amount (if it’s worth it to you) or going with the standard deduction.
A credit is an expense that the IRS allows to you “credit” against the amount of tax that you owe. In other words, if you owe $3,000 in taxes and also have an education credit of $1,500, you now only owe $1,500!
There are two basic types of tax credits:
Non-Refundable Tax Credit
In the example above, the amount you owed in taxes was larger than the amount of your credit; but what if that wasn’t the case? Let’s say that you owe $1,000 in taxes and you have a non-refundable credit of $1,500. In this case, your tax liability is brought down to $0, but you are not entitled to a refund.
While these types of credits still come in handy when you owe money, they are pretty much worthless if you are already getting a refund!
Refundable Tax Credit
These are the fun ones! Let’s say you still owe $1,000 but now your $1,500 credit is refundable; this means that you will receive a $500 refund!
A refundable credit allows you to apply the full amount of the credit against what you owe in taxes. So, even if you are slated to get a refund (which really is simply owing a negative amount), the credit will just add to it!
Why is This Important?
When you want to decide if a particular move makes financial sense, it’s important to consider the tax implications. The first step in doing this (after figuring out if you qualify) is to determine if you are eligible for a credit or a deduction.
For instance, many people will purchase a home in the near future and be told about all of the wonderful tax benefits of their decision. Maybe you’re considering purchasing a home but can’t imagine paying a huge sum of money each year for your home. Usually, someone will say, “but you’re forgetting the tax ‘write-off’”!
Let’s take a look at some numbers to see how great this benefit will be. The first thing to note is that the IRS will allow you to take a deduction for mortgage interest and for property taxes paid during the tax year.
If you purchase a home and need to take out a $350,000 mortgage, at 5%, for 30 years, you will pay approximately $22,546 each year! In the first year of the mortgage, approximately $17,383 of that will go toward interest!
It is [very] wrong to assume that you will reduce the amount of tax you owe by $17,383! However, I see many people make this type of assumption when arguing in favor of a certain expense (buying a house, business expenses, etc)!
In order to figure out what your true tax benefit will be, just multiply it by your marginal tax rate. For tax year 2010, a single person making $65,000 a year would have a marginal tax rate of 25%. That means that you will owe $4,346 less in taxes if you applied this deduction.
However, since it is less than your standard deduction (see above), there is really no benefit at all – unless you have other deduction (like property taxes, for instance).
As we mentioned above, if this were a tax credit, then the entire $17k would be used toward reducing your tax bill. And if it’s refundable, then you’ll actually get a refund once your full tax due has been covered.
As you can see, this is a very simple, yet very important concept that you must understand if you are going to evaluate most major financial decisions properly.
Khaleef writes about personal finance from a biblical perspective for KNS Financial’s “Faithful With A Few” blog. KNS Financial provides Personal Financial advice, Budgeting Assistance, Tax Preparation and Advice, Debt Management, and Economic Commentary, through personal consultations, writing, seminars, and workshops