Every year we are required to file our federal and state tax returns. For some of us, taxes are automatically taken out of every paycheck to pay our tax bills . . . and if we’re lucky we may even receive a refund of some of that money.
Then there are other folks who do not have money taken out of their paychecks. Most of those workers are self-employed and/or own their own businesses. They pay taxes by making periodic (usually quarterly) tax payments. That’s where the terms tax deduction and credit come into play!
These techniques are legal ways for self-employed taxpayers and business owners to lower their IRS tax bills. And, they are also some of the most misunderstood in the tax world! Here is an overview of the basic differences.
Tax deductions reduce the amount of income that is taxable (“taxable income”) by subtracting allowable tax-deductible “expenses” from the total income earned. So, a deduction only lowers the amount of income that is taxed. It does not directly help in lowering the bottom-line tax bill that is owed. Rather, it is an indirect way of tax savings.
For example, if you earned $100,000 and had $20,000 in deductible expenses you would only pay tax on $80,000 of your income. So, if you were in a 30% tax bracket your tax bill would be 30% of $80,000 (which equals $24,000) instead of 30% of $100,000 (which equals $30,000).
On the other hand, tax credits are subtracted directly from your tax bill. So, in our example above, if your tax bill was $24,000 but you qualified for a $4,000 tax credit your bottom-line tax bill would be reduced by that amount to $20,000.
The other big consideration with credits is that there are two types: re-fundable and non-refundable. Refundable credits are just that – they can generate refunds to the taxpayer. In other words, you could be entitled to be paid a tax refund even if you do not owe anything. For example, if you have a bottom-line tax bill of $500 but you also qualify for a tax credit of $1000, then you are eligible for a refund of $500.
Conversely, if the credit were to be non-refundable you would not be eligible to receive a refund. Instead, the credit would simple zero out the tax bill.