Business & Finance Finance

Small Business Tax Tips - What" s The Difference Between A Tax Deduction And A Tax Credit?

Do you understand the difference between a tax deduction and a tax credit? This story should clarify the difference.

A self-employed taxpayer (let's call her Debbie) meets with her accountant to discuss her income tax return. She was quite distraught because she had a balance due of $400. She could barely stand the thought of paying the government any more money.

"After all", she said, "I've already paid them several thousands dollars! Isn't that enough! They don't deserve another dime of my money, so I'm going to go back home and check my records one more time to see if I can find some more deductions."

Don't you sympathize with Debbie? You can certainly understand her frustration. It does seem unfair that a taxpayer pays in thousands of dollars during the year, and then has to turn around and write a check on April 15 for another $400.

And Debbie had the right attitude about finding more deductions. Many taxpayers leave a lot of money on the table when they don't take all the deductions they are legally entitled to. Debbie should be commended for her determination to find some more deductions to lower the $400 balance due.

On her way out the door, Debbie proclaims: "I know I can find another $400 worth of deductions. I have some receipts that I didn't bring in yet, and if those receipts add up to $400, I'll feel much better if I just 'break even' instead of paying the IRS more money."

Her accountant rushes over to the door to stop Debbie from leaving.

"What do you mean, 'If those receipts add up to $400 I'll break even'?" he asks.

"Well," said Debbie, "Don't I just have to find another $400 in deductions to reduce my tax bill down to zero?"

"Sit down, Debbie. We need to have a little chat before you go."

Her accountant tells Debbie that finding another $400 in deductions would not reduce her tax by $400. Instead, that additional $400 in deductions would only reduce her taxable income by $400. How much actual tax she would save would not be $400.

Debbie was confusing a tax deduction with a tax credit.

To know how much tax savings would result from a $400 deduction required another calculation. And to do that calculation, she had to know what her tax rate was.

It turns out that Debbie was in the 25% tax bracket. In other words, the highest tax rate percentage that she paid on her income was 25%. So, if she reduced her taxable income by $400 of additional deductions, her actual tax savings would be: $400 x 25% or $100. She would save $100, not $400.

Debbie was shocked. "You mean I must have more than $400 in deductions in order to save $400 in taxes?"

"That's right," her accountant said. "To reduce your taxes by $400, you need an additional $1,600 in deductions." He took out a sheet of paper and wrote down the following calculation: $1,600 x 25% = $400.

Debbie was now distraught once again. "There's no way I can come up with that amount of deductions. I guess I'll just have to pay."

"Well, go ahead and find whatever deductions you can. Then you can calculate your tax savings by doing this simple multiplication problem: deduction x tax rate of 25% equals tax savings." In other words, since Debbie was in the 25% tax bracket, all she had to do was multiply her deduction amount by her tax rate percentage to figure out her tax savings.

This principle applies to any taxpayer. Once you know your tax bracket, you can see how much tax you'll save if you take some additional deductions. A deduction does not reduce your tax dollar for dollar; instead, a deduction only reduces your taxable income dollar for dollar.

Our tax code does have something else called a tax credit that does reduce your tax liability dollar for dollar. There are several of these tax credits available, like the child tax credit, the child care credit, and the earned income credit.

Now you know the difference between a tax deduction and a tax credit.

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