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Friday, February 4, 2011

Differences between tax credits and tax deductions

There are a few differences between a tax credit and a tax deduction. These differences can pertain to the affect on tax owed,  how they are reported, how they are determined, what they are derived from, how they are qualified for and  the reasons for their existence. Tax credits and tax deductions are financial, legal and political tools with different goals, functions, calculations and varying degrees of benefit. Financially, the benefit of reduced tax is well recognized, and may be held as most important by tax-payers.

• Direct vs Indirect reduction to tax owed
• Tax deductions are calculated before tax credits
• Credits can have a greater impact on tax due
• Tax credits often require individual forms to be filed
• Both may serve different functions, and goals
• Tax credits may apply to a smaller demographic

One of the most financially beneficial differences between a tax credit and a tax deduction is the amount of tax that is reduced from the tax filers obligation to the Government. In other words, the tax savings and potential tax refund is often higher with tax credits than with tax deductions. For example, a tax credit of $400 would require a tax deduction of $1,600 at a 25% tax rate to amount to the same reduction in tax owed to the Government. Thus, the more tax credits a tax filer can legitimately qualify for, the better it is for reducing tax.

Tax deductions and tax credits are reported using the IRS Form 1040 for individual and family tax filers. Deductions are either reported on the Form 1040 and/or with a Schedule A whereas tax credit are recorded using specific tax credit forms. Moreover, multiple deductions can be recorded and added on an IRS Schedule A, however tax credits are determined and recorded one at a time with different forms.

There is more paperwork required to be submitted for tax credits than tax deductions. An example of a tax credit is the Child Tax Credit that requires one to be the parent of a qualified child to be claimed according to IRS Form 972 the U.S. Department of the Treasury’s ‘1040 Forms and Instructions’ publication.

The legislation governing tax credits and tax deductions is different. Tax deductions tend to be more generalized whereas tax credits may be more targeted. Moreover, tax credits involve specific short-term Government agendas such as stimulating the economy, boosting a sector in the economy or assisting a specific population group. Tax deductions on the other hand include expense reductions that many people of a larger demographic may qualify for over time. For example, mortgage interest expenses are a tax deduction that can be claimed on IRS 1040 Schedule A. However, the First Time Homebuyers Tax Credit and the Repeat Homebuyers Tax Credit both expire and require the property to be a primary residence. Hence, the tax credits are more limited than the mortgage interest deduction.

The aforementioned difference between a tax credit and tax deduction is not always the case, or at least, does not always hold such a pronounced difference in function. This is evident in the IRS Hope Education Credit and the IRS Tuition and Fees Deduction. Both the Hope Education Credit and Tuition and Fees Deduction are tax reductions based on educational expenses. Besides the affect they have on tax due, they serve similar ends i.e. to help assist the goal of education. In this sense they are similar, however the tax credit amplifies the tax benefits by also assisting parents of students who help pay for their children’s education and those with incomes below a certain level.

Another difference between a tax credit and a tax deduction is how they are calculated. The two kind of have an inverse pattern in terms of how they are calculated and reported. Tax credits may be a percentage of a total expense but a direct reduction to tax whereas a deduction may be a direct reduction to taxable income, but only a percentage reduction to tax. Tax credits may also rely less on worksheets, and more on tax forms for their calculation and determination. For example, IRS Form 8863 is used to claim the Hope Education Credit whereas the IRS Student Loan Interest Deduction Worksheet is used to determine the Student Loan Interest Deduction.

In summary, the difference between a tax credit and a tax deduction varies depending on the specific deduction and credit being claimed. However, tax deductions may be less likely to have maximums than credits, are often able to be claimed by a wider group of tax payers and don’t always expire as quickly as some tax credits. Tax credits are reported on IRS Form 1040 like tax deductions, however tax credits often also require the use of specific tax forms designed for the tax credit whereas deductions may use IRS 1040, Schedule A instead.

Tax credits can reduce taxes more than tax deductions if the tax credit is greater than the percentage amount of the tax deduction claimed. Sometimes, tax deductions can be claimed alongside tax credits even if they serve similar purposes, an example of such being the traditional IRA deduction and the Retirement Savings and Contribution Credit. So even though there are differences between the tax credit and tax deduction there are also similarities and tax credits do not necessarily amount to more than a tax deduction.

Source: http://www.irs.gov (U.S. Internal Revenue Service)