You’ve probably heard of “tax credits” and “tax deductions” before. What are they? Are they the same thing? If not, which one is better? Let’s dig in!
A tax credit is an amount of money that taxpayers can subtract directly from the taxes they owe. The value of a tax credit depends on the nature of the credit; certain types of tax credits are granted to individuals or businesses in specific locations, classifications, or industries. (Investopedia)
A few examples of tax credits:
– Credit for child and dependent care expenses (age 13): The credit is a percentage of expenses actually paid for care of a dependent to enable the taxpayer to work and earn income.
– Child tax credit: Individuals may claim a child tax credit of $2,000 (2021) for each qualifying child under age 17. The credit is available for a son, daughter, stepchild, or foster child.
A tax deduction is an item you can subtract from your taxable income to lower the amount of taxes you owe. You can choose the standard deduction—a single deduction at a fixed amount—or itemize deductions on Schedule A of your income tax return.
If the value of your itemized expenses is greater than the standard deduction for your filing status, it makes sense to itemize. Allowable itemized deductions include mortgage interest, charitable gifts, unreimbursed medical expenses, and state and local taxes. (Investopedia)
Okay, so now that we’ve gotten the definitions of a tax credit and a tax deduction out of the way, which one is better?
Like most answers in finance, “it depends”.
A tax CREDIT is worth more to a LOW-BRACKET taxpayer.
A tax DEDUCTION is worth more to a HIGH-BRACKET taxpayer.
Let’s look at an example.
Peter makes the following credits/deductions on his taxes: $4,000 deductible IRA contribution, $2,000 childcare credit.
If Peter were in the 35% tax bracket, the equivalent credit for his IRA deduction would be $1,400 ($4,000 x .35)
If Peter were in the 35% tax bracket, the equivalent deduction for the childcare credit would be $5,714.29 ($2,000 / .35)
If Peter were in the 12% tax bracket, the equivalent credit for his IRA deduction would be $480 ($4,000 x .12)
If Peter were in the 12% tax bracket, the equivalent deduction for the childcare credit would be $16,667 ($2,000 / .12)
So, by finding the equivalent credits/deductions, you can see that the deduction is worth LESS if Peter is in the LOWER tax bracket ($480 vs. $1,400)
You can see that the credit is worth LESS if Peter is in the HIGHER tax bracket ($5,714.29 vs. $16,667)
MORAL OF THE STORY
That was a long-winded, math-filled way to illustrate two points: credits = better for low tax brackets, deductions = better for high tax brackets.
And remember, when it comes to tax credits and tax deductions, it’s “good vs. better” not “good vs. bad”.
Even if you’re a high tax bracket filer, tax credits are still GOOD.
Even if you’re a low tax bracket filer, tax deductions are also still GOOD.
If you have any questions, or I lost you in the math-formula portion, and want to talk about it – shoot me an email! You can find me at firstname.lastname@example.org OR you can click here to schedule a meeting with Mullooly Asset Management! And don’t forget to check out today’s Top Links!