Tax deduction vs tax credit
A deduction reduces your taxable income; a credit reduces your tax bill directly. Credits are worth more, dollar for dollar.
A tax deduction lowers the income that gets taxed. If you earn $80,000 and have $10,000 in deductions, you're taxed as if you earned $70,000. The dollar value of the deduction is deduction amount × marginal tax rate. A $10,000 deduction at a 22% marginal rate saves you $2,200 in tax.
A tax credit is subtracted directly from your tax bill. A $1,000 tax credit lowers your tax owed by $1,000, full stop — regardless of your bracket. Worth more, dollar for dollar, than a deduction of the same size.
Credits come in two flavours:
- Non-refundable: can reduce your tax to zero but no further. If you owe $500 and have a $1,000 credit, you get to zero — the extra $500 is lost.
- Refundable: can produce a refund. If you owe $500 and have a $1,000 refundable credit, you owe -$500 (the government sends you $500).
Common credits (US): Child Tax Credit, Earned Income Tax Credit, education credits. Common deductions: mortgage interest, state and local taxes (capped), charitable contributions, the standard deduction itself.
Cashowa gives tax tips, not tax filing. Always run anything material past a CPA before filing.
See also
- Marginal vs effective tax rate — Marginal rate is the rate on your next dollar of income; effective rate is the average rate across all your income.
- Pre-tax vs post-tax contributions — Pre-tax contributions reduce your taxable income now but are taxed at withdrawal. Post-tax (Roth) contributions don't reduce taxes now but are tax-free at withdrawal.
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