Read a great post from Kailey Fralick on The Motley Fool breaking down the difference between two exciting things that reduce the amount of money you own the government. H/T @TMFKaily
From “What’s the Difference Between a Tax Deduction and a Tax Credit?”:
Tax deductions reduce your amount of taxable income in the eyes of the IRS, or in other words, how much money the government will consider in deciding what rate to use in taxing your income and how much cash to apply that rate to in tallying up your tax bill.
If you take a $1,000 tax deduction, your taxable income for the year will be reduced by $1,000. Depending on your annual income and how many tax deductions you qualify for, you could wind up in a lower income tax bracket, resulting in the government taxing a smaller percentage of your earnings.
Even if your tax deductions don’t change the bracket you occupy, allowing you to be taxed at a lower rate, they can still reduce the amount you owe in tax, by reducing your taxable income. You can figure out how much you’re saving by multiplying the value of the deduction by the income tax bracket you’re in. For example, a $1,000 tax deduction would be worth $220 off the tax bill for someone in the 22% income tax bracket.
I hope these definitions and examples help to clarify what these two commonly-heard tax terms mean–and what they could mean for you.
What is a tax credit?
Tax credits reduce the amount of taxes you owe, but instead of doing so by reducing your taxable income, tax credits reduce your actual tax liability, acting as a dollar-for-dollar reduction of your tax bill.
If you qualify for a $1,000 tax credit, the total in taxes you owe will be reduced by $1,000. So to answer the question at the start of this article: You’re much better off taking the $1,000 tax credit over the $1,000 tax deduction.
When it comes to tax credits, there are two main types: refundable and nonrefundable. Refundable tax credits offer the better deal, if you can take advantage of them, because if their value exceeds your tax liability, the government will actually refund you the difference. Nonrefundable tax credits may reduce your tax liability to zero, but the government does not refund you any excess once you hit zero.
One of the most common refundable tax credits is the earned income tax credit (EITC). It’s designed to help lower-income families, especially those with dependent children, save on their taxes. The maximum income requirement to use in qualifying for the EITC depends on your tax filing status and your number of qualifying children. This tax credit could be worth $519 for the 2018 tax year to couples with no children, $3,461 to families with one child, $5,716 to families with two children and $6,431 to families with three or more children. If these amounts exceed your total tax liability for the year, the government will give you the difference in your tax refund. This means it’s still worth filing a tax return if you will qualify for this benefit, even if your income for 2018 is less than $12,000, meaning you’re not legally required to file a tax return.
Joseph T. Martin Income Tax Service 