Credits reduce tax
Deductions reduce income
Credits are worth more

A recent FiKu discussed the difference between above and below-the-line deductions.

This week we’ll continue on that theme and discuss the difference between a tax credit and a tax deduction. If you read no further than this paragraph, this should be the takeaway: in the same way that an above-the-line deduction is worth more than a below-the-line deduction, a tax credit is more valuable than a tax deduction.

A tax credit directly reduces taxes, dollar for dollar. The $3,000 Child Tax Credit, for example, directly lowers a taxpayer’s tax bill by $3,000 per child.

Deductions, on the other hand, reduce taxable income, which indirectly reduces taxes.

Suppose instead of a $3,000 credit, you have a $3,000 above-the-line deduction. Furthermore, let’s assume your gross income for the year was $100,000. The deduction reduces your income to $97,000. If you are married, that amount of income puts you in the 22% tax bracket.

To calculate the value of your deduction, simply multiply the deduction by your tax bracket.

$3,000 x 22% = $660.

Your $3,000 deduction saved only $660 in taxes.

What amount of deduction would it take for someone in the 22% tax bracket to get a $3,000 reduction in taxes? You can calculate this by dividing $3,000 by your tax bracket.

$3,000 ÷ 22% = $13,636.

Mathematically, a $3000 tax credit is worth a deduction of $13,636 to a taxpayer in the 22% tax bracket.

This is where tax planning can be valuable. In order to qualify for many tax credits, your Modified Adjusted Gross Income must fall within certain thresholds. By using deductions to reduce income, you may put yourself within those thresholds.

This interplay between deductions and credits - using deductions to reduce income to qualify for credits to reduce taxes - creates a powerful combination that may help prevent taxpayers from leaving Uncle Sam a tip on April 15th.

Are you interested in reviewing your taxes to see if a tax plan might help you keep more of your money? Let us know, we’d love to hear from you.