What’s The Difference Between Deductions And Credits?
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How does a tax deduction work?
A deduction works by reducing your taxable income.
How does a tax credit work?
A credit works by reducing the amount of tax you owe, regardless of your taxable income.
What is taxable income?
Taxable income is the number the IRS uses to calculate the amount of tax you owe. Taxable income also determines what tax bracket you fall in.
A tax deduction Example
If my taxable income is $100,000 and I receive a deduction for $1,000 my new taxable income will be $99,000. This means the IRS will use $99,000 to determine how much I owe in taxes.
A tax Credit Example
If the IRS says I owe $5,000 in taxes and I have a credit for $1,000, I will only owe $4,000 in taxes.
What are refundable credits?
Some tax credits are even refundable. A refundable credit means you can receive money for the credit or remaining credit once your tax liability (how much you owe in taxes) is reduced to zero.
A Refundable tax Credit Example
If I owe $200 in taxes and have a refundable credit for $500, I am eligible to receive a tax refund of $300.
Just remember, not all credits are refundable.