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Tax Deduction vs Tax Credit

Tax credits and tax deductions may be the most satisfying part of preparing your tax return. Both reduce your tax bill, but in very different ways.

DEDUCTIONS

Deductions reduce how much of your income is subject to taxes. Deductions lower your taxable income by the percentage of your highest federal income tax bracket. So, if you fall into the 22% tax bracket, a $1,000 deduction saves you $220.

CREDITS

Tax credits directly reduce the amount of tax you owe, giving you a dollar-for-dollar reduction of your tax liability. For instance, a tax credit valued at $1,000 lowers your tax bill by $1,000.

Generally, tax credits are more valuable than tax deductions. However, there are times when a deduction can be more useful if it reduces your adjusted gross income (AGI) to allow you to take advantage of tax breaks you wouldn’t receive if your AGI were higher.

REFUNDS

Some tax credits are refundable or partially refundable, like the child tax credit or the American opportunity tax credit. That means if your calculated tax is $600 and you have a refundable tax credit of $1,000, you’ll receive a $400 refund. But most tax credits are non-refundable. That means you won’t receive a refund if using a tax credit reduces your tax bill below $0.

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December 2022 Client Profile

Vince owns a construction company, and during the holidays, he lets employees volunteer at their favorite charity and pays them for their time. Can he deduct these employee payments from his business tax return?

Although Vince is serving his community by encouraging his staff to contribute their time or skills to charity, the payment he makes to his employees doesn’t qualify as a charitable deduction. Instead, he should pay his employees if they volunteer during regular working hours, which would be recorded as payroll expenses.

However, if he incurs direct, non-payroll expenses on behalf of his employees’ volunteer efforts, he generally can deduct those as a charitable contribution. For example, if he supplies building materials for his employees to serve with Habitat for Humanity building homes, the construction materials he provides will be tax deductible. He needs to keep receipts for all donated materials and may need a written acknowledgment for amounts over $250.

Client Profile is based on a hypothetical situation. The solutions discussed may or may not be appropriate for you.