Tax Credit
What is Tax Credit?
A tax credit directly reduces the amount of tax owed, dollar for dollar.
It is more valuable than a deduction of the same size, which only reduces taxable income. Refundable credits can even produce a payment if they exceed the tax owed. Examples include the Earned Income Tax Credit.
Tax Credit: a worked example
Compare a $2,000 credit with a $2,000 deduction for a filer whose marginal rate is 25% and whose tax before either comes to $9,000. The deduction cuts taxable income by $2,000, saving 0.25 × $2,000 = $500, so tax falls to $8,500. The credit is subtracted from the tax itself: $9,000 − $2,000 = $7,000, a saving four times as large. Now suppose the same filer owed only $1,200. A nonrefundable credit wipes the bill to $0 and the remaining $800 is lost; a refundable one pays that $800 out as a check.
The mistake students make with tax credit
The frequent error is treating a credit and a deduction as the same "write-off" and assuming a $1,000 deduction cuts the tax bill by $1,000. A deduction is worth your marginal rate times its size, so at a 25% rate it saves $250, while a $1,000 credit saves the full $1,000. The mix-up is understandable, because tax software presents both as things that lower what you owe. The second trap is assuming every credit is refundable; a nonrefundable one stops once tax reaches zero.
Tax Credit questions
What is the difference between a tax credit and a tax deduction?
A tax credit subtracts directly from the tax you owe, while a tax deduction subtracts from the income the tax is calculated on. That makes a credit worth its full face value to everyone who can use it, but a deduction worth only the taxpayer's marginal rate times its size. The same deduction is therefore worth more to a high-rate filer than to a low-rate one, while a credit is not.
What does a refundable tax credit mean?
A refundable tax credit pays out the leftover amount in cash when the credit is larger than the tax owed. If a $3,000 refundable credit meets a $1,100 tax bill, the filer owes nothing and receives $1,900 back. A nonrefundable credit in the same situation only zeroes the bill, and the extra $1,900 disappears, which is why refundability matters most for low-income filers.
Do tax credits reduce taxable income?
Tax credits do not reduce taxable income. Credits are applied after tax has been computed from the bracket schedule, so they change the final bill without changing which bracket you land in or the rate on your last dollar. Deductions and exemptions are the items that shrink taxable income, and only those can move a filer into a lower bracket.
Related terms
Common comparisons
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