Although these two terms are used interchangeably, when you’re discussing tax credits and tax deductions you’re not comparing apples to apples. They are very different and knowing the differences is helpful.
Tax we owe in any given year is not based solely on our income but is also affected by the various tax dedications and tax credits we are entitled to for that year.
Tax Deductions – Reduce Taxable Income
Tax deductions reduce taxes differently depending on the marginal tax bracket you’re in. For example, if you are in the bottom marginal tax bracket and your marginal tax rate is 15%, then a $100 tax deduction will save you $15. However, let’s say you were in a higher marginal tax bracket and your marginal tax rate is 20%, then that same $100 tax deduction will save you $20 instead. Although tax deductions will generally benefit everyone, tax deductions are more effective in saving tax for those that make a higher income and are subject to higher tax rates.
Common tax deductions include:
Tax Credits – Directly Reduce Tax Liability Otherwise Calculated
Once your marginal tax rate is applied to your taxable income and the taxes owing is calculated, tax credits are applied in the final stage of this calculation to lower taxes owing even further. Tax credits differ from tax deductions because they reduce taxes independent of the marginal tax bracket you belong in. Tax credits are calculated using the bottom marginal tax rate. In other words, whether you have a taxable income of $30,000 or $200,000, a $100 tax credit will save you the same amount in taxes. Tax credits might bring your final tax owing to $Nil but are generally not going to create a tax refund.
Common tax credits include:
Bottom line is, tax deductions will save more taxes than tax credits if you are in the higher marginal tax brackets. So remember, you aren’t deducting that medical expense, you’re claiming a non-refundable tax credit.
We hope this brief explanation of the differences between tax deductions and tax credits will help you better understand what’s going on inside your tax return. Please call us if you have any other questions or comments.