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Understanding tax credits vs. tax deductions

Can you explain the difference between a tax credit and a tax deduction and how they affect a person's tax return?

As most taxpayers prepare their 2011 tax returns this season, it is important to understand how tax credits and tax deductions work and how they differ from each other. A tax credit reduces your tax liability, dollar for dollar whereas a tax deduction reduces the amount of your taxable income, which is used to calculate your tax liability.

Generally, tax credits can be more valuable because they directly offset the actual taxes you pay (i.e., your tax liability), dollar for dollar. For example, if a taxpayer has $100,000 of taxable income (before tax credits and deductions) and a marginal tax rate of 25 percent. The taxpayer's tax liability would be $25,000 before any tax credits or deductions are applied. A $3,000 tax credit would reduce the $25,000 tax liability to $22,000, resulting in an effective tax rate of 22 percent. A $3,000 tax deduction would reduce the taxpayer's taxable income to $97,000 ($100,000 - $3,000). If the taxpayer's marginal tax rate is 25 percent, the taxpayer would have a tax liability of approximately $24,250 or an effective tax rate of 24.2 percent. The $3,000 tax credit yields a 2.25 percent higher savings on the taxpayer's tax liability.

Tax credits can be even more valuable if they are refundable. Tax credits can be refundable or non-refundable. If the tax credit were a refundable credit, you would receive a tax refund if the credit exceeds the amount of your tax liability. If the credit were not refundable, you would not be able to reduce their tax liability below zero (even if the amount of the credit exceeds your tax liability). For example, if your tax liability is $2,000 and you have a refundable tax credit of $2,500 you will receive a $500 refund. If the $2,500 tax credit is not refundable, it will reduce your tax liability to zero but will not receive the balance any refund beyond that.

(Note: Keep in mind that the above examples simplify the calculation of the taxpayer's tax liability to illustrate the effect of credits and deductions. These examples are not meant to suggest that a person will pay their full marginal tax rate on their entire tax liability.)

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