The Major Distinction Between a Deduction and Credit
The Internal Revenue Service and state revenue authorities assess taxes on individual incomes in order to raise money for government services. At the federal level, the IRS allows taxpayers to use exemptions, deductions and credits to reduce the potential tax liability. The major distinction between credits and deductions is the overall effect on a taxpayer's total tax due.
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Income
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The Internal Revenue Service assesses taxes on your adjusted gross income. Courts define gross income as all accessions to wealth, clearly realized, over which the taxpayer has complete control. Wages, dividends, alimony, capital gains and rental income are common examples of income. Adjusted gross income is the amount of income left over after subtracting applicable deductions and using your exemptions.
Deductions
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Deductions reduce your total taxable income. The IRS determines your total tax based on your tax bracket. For example, assume you earned $25,000 in 2011. The IRS taxes 13.3 percent of that income. Without taking into consideration deductions, exemptions or credits, you would owe $3,325 in taxes. Now assume that you earned $25,000 in 2011, but you have $1,500 worth of deductions. Your taxable income is $23,500. The IRS assesses a 13.19 percent tax on the amount. After factoring in deductions, your tax liability is $3,100. The deductions only reduced your tax liability by $225. Deductions have less of an impact on your total tax liability than tax credits.
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Credits
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Unlike deductions, credits reduce your tax liability by the full credit amount. If you qualify for a tax credit worth $500, and your total tax owed is $1,000, the credit reduces your tax liability by the full $500; your total tax liability would be cut in half. Credits can only reduce your tax liability down to $0. If you qualify for a tax credit worth $500, but your total tax liability is $300, the credit would wipe out your tax liability, but you would not receive the other $200. Contrast that to payments. Payments--such as the Earned Income Credit and the First-Time Home Buyer Credit--not only reduce your tax liability like a credit, but also may provide you with a refund.
Exemptions and Other Issues
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Personal exemptions function like deductions: They reduce your taxable income but do not lower your tax liability dollar by dollar. Deductions and exemptions may lower your income into a more favorable tax bracket. However, an article on Kiplinger.com suggests taking the tax credit if you have to choose between a credit or deduction. In general, tax credits lower your potential tax liability more than deductions.
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