As tax time approaches again on April the 15th, questions continue to come up. One of the most common questions involves a tax deduction versus a tax credit. Many people think that these two tax terms are interchangeable, but that is not true at all. It is very important to understand the difference between a tax deduction and a tax credit. The financial implications are very different and knowledge is always the key to making better financial decisions before you even have to file taxes.

Tax deduction

A tax deduction is a reduction to taxable income. Its true value varies from person to person and is totally dependent on their respective tax bracket. For instance, suppose Don and Juan each get an $8000 tax deduction for purchasing a new home.

Don is a doctor and is in a high tax bracket of 30%. The $8000 will offset $8000 worth of his taxable income and save him $2400 (30% times $8000) on his tax bill.

Juan is a worker in a factory and is only in the 15% tax bracket. For Juan the $8000 deduction reduces the same $8000 worth of income, but will only save him $1200 (15% times $8000) on his tax bill. The difference is easy to see. So remember a tax deduction just reduces the amount of taxable income. It prevents a tax debt from occurring at the start.

Tax creditsTax credit

A tax credit is a dollar-for-dollar reduction on the amount of tax you owe. If Don and Juan each have a $8000 tax credit coming, this means they OWE $8000 less on their taxes. For instance, if Don the doctor owes $45,000 on his income then he can reduce this to $37,000 ($45,000 - $8,000). For poor Juan who owes $5000 on his income, then he will get $3000 back ($5000 - $8000). Sometimes a credit will only let you go down to zero liability, so worse case Juan is still able to wipe his entire tax bill away. Also, sometimes tax credits are subject to maximum income levels to take the entire credit. A tax credit is why so many families do well with the child care credit or the earned income credit. A credit is far more powerful than a deduction is most all cases.

Now that you see the difference between tax deductions and tax credits you will pay closer attention to different programs and offers available to you. The current new homebuyer program is offering $8000 tax credits to new homebuyers and $6500 in tax credits to others meeting certain qualifications. This understandably shows why this is a limited time offer from the government as they are basically giving money away. Tax credits are far more likely to be phased out quicker than tax deductions. This makes sense since it takes more money out of Uncle Sam's pocket!