Oh no. That topic. Taxes. I know many of us would rather go to the dentist than talk taxes. So I promise I’ll make this as short and sexy as possible, so that you can take this knowledge, save money, and live it up for less.
So to know the difference between income tax credits and deductions, you just have to understand three concepts: marginal tax rates, credits, and deductions. Let’s go.
Marginal Tax Rates
An example is the only real way to explain this. Say I make $150,000 in a year (yay!), and that my tax rates are 10% for the first $50,000, and 25% for other $100,000.
So, step one is to take that first $50,000 of income, and remove 10% from it ($5,000).
Step two is to take the remaining $100,000 of income, and remove 25% from it ($25,000).
Step three is to add them, for a total tax of $30,000 ($5,000 plus $25,000).
That’s it. The other alternative is a flat tax which would be, for instance, 10% of all income. In that case, I would pay $15,000, which is 10% of $150,000.
By the way, the amount of tax you owe is what accountants call your tax liability.
Income Tax Credits
Simple. A credit is money you don’t have to pay; it’s just subtracted from the taxes you would owe. So say I owed those $30,000, and I got a credit of $10,000. I remove it from the $30,000, and just have to pay Uncle Sam $20,000.
A little more complicated. Deductions are money you remove from your income, not from your taxes owed.
So, following the above example of marginal rates, let’s say I get a deduction of $50,000 because I bought a McMansion that I can’t afford and am paying all of that in mortgage interest (which is normally tax-deductible).
I remove those 50 large from my income, to get a taxable income of $100,000. Then, I figure out my taxes on the basis of that income:
Step one: 10% of the first $50,000 comes out to $5,000.
Step two: 25% of the second $50,000 comes out to $12,500.
Step three: $5,000 plus $12,500 equals $17,500.
So my total tax debt is $17,500, which means that the deduction reduced my taxes by $12,500 (because I now owe $17,500 instead of $30,000).
What This Means
Income tax credits are better for you than deductions, since they straight-up reduce your taxes, rather than your taxable income. That’s why I don’t really buy into the argument that deductions are the most wonderful thing in the world. They’re great, but if I paid $50,000 in mortgage interest and thereby reduced my taxes by $12,500, I still “paid” $37,500 in mortgage interest. Ouch!