What Are Tax Deductions And Tax Credits, And How Do They Differ?

Understanding Tax Deductions and Tax Credits

1. Tax Deductions:

1.  Definition: Tax deductions subtracted from gross income reduce taxable income, lessening overall tax liability for taxpayers.   

2. Types of Deductions: Deductions can be categorized as either "above-the-line" or "below-the-line" deductions:

     i) Above-the-line deductions: Known as adjustments to income, deductions like retirement contributions and student loan interest subtracted from gross income arrive at adjusted gross income (AGI).

     ii)  Below-the-Line Deductions: Taxpayers decide between itemized deductions or the standard deduction, with common below-the-line deductions like mortgage interest and charitable contributions.

3. Effect on Tax Liability: Deductions lessen taxable income, diminishing the taxpayer's tax liability, with actual savings dependent on the marginal tax rate—higher rates yield greater savings.

2. Tax Credits:

   a) Definition: Tax credits directly decrease the tax owed by a taxpayer, providing dollar-for-dollar reductions, unlike deductions which lessen taxable income.

   b) Types of Credits: Tax credits can be categorized as either refundable or non-refundable:

     i) Refundable Tax Credits: Refundable tax credits can lead to a refund when the credit surpasses the tax liability, allowing taxpayers to receive the excess amount as a refund if their liability is reduced to zero.

     ii) Non-refundable Tax Credits: Non-refundable tax credits lower tax liability to zero but cannot generate a refund; any excess credit beyond the liability is typically forfeited.

   c) Effect on Tax Liability: Tax credits directly cut the taxpayer's tax owed by the same amount, such as a $1,000 credit reducing tax liability by $1,000, irrespective of the taxpayer's marginal tax rate.