When it comes to taxes, the terms "tax deduction" and "tax credit" often get thrown around—and they might sound pretty similar if you're new to them. While both can help reduce your tax bill, they work in entirely different ways. Knowing the difference can make a big impact when tax season rolls around.

What Is a Tax Credit?

A tax credit is a direct reduction of the amount of tax you owe. Think of it as a dollar-for-dollar discount on your tax bill. If you owe $1,000 in taxes and have a $500 tax credit, your bill drops to $500—simple as that!

Tax credits come in two flavors: nonrefundable and refundable.

• Nonrefundable Credits: These can reduce your tax bill to zero, but nothing more. If your tax liability is $400 and your nonrefundable credit is $500, the extra $100 won’t come back to you.
• Refundable Credits: These can not only bring your tax bill to zero but also put money back in your pocket. Using the same scenario as above, if you have a $500 refundable credit, you’ll get a $100 refund.

Common examples of tax credits include the Child Tax Credit, Earned Income Tax Credit, and Education Credits like the American Opportunity Tax Credit.

What Is a Tax Deduction?

A tax deduction, on the other hand, lowers your taxable income. Instead of directly reducing the taxes you owe, it decreases the income the government can tax.

For example, if you made $50,000 last year and have $5,000 in deductions, your taxable income becomes $45,000. This reduces the amount of tax you owe, but the savings depend on your tax bracket.

Common tax deductions include student loan interest, mortgage interest, charitable contributions, and business expenses. If you haven’t already, sign up for our newsletter and get a list of 50 commonly overlooked tax deductions right in your email.

Tax Credit vs. Deduction: An Example

Let's break it down with an example:

• Tax Credit Scenario: If you owe $1,000 in taxes and qualify for a $1,000 tax credit, your tax bill could be completely wiped out.
• Tax Deduction Scenario: If you have a $1,000 deduction and you're in the 22% tax bracket, your deduction would reduce your taxable income by $1,000, saving you $220 on your tax bill.

The bottom line? While both tax deductions and credits can save you money, tax credits tend to have a bigger impact on your bottom line.

Need Help Navigating Tax Credits and Deductions?

Understanding the difference between tax credits and deductions—and knowing how to claim them—can make a world of difference at tax time. Need help managing your business’s financial reporting? Book a connection session today and let’s ensure you’re on track for compliance and success!

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