This is a guest post about understanding taxes by Steve Cook. He is an associate at a boutique Phoenix, AZ-area tax law firm that handles various tax-related matters including estate planning, probate, business and real estate law. The firm operates a blog to which Steve regularly contributes.
Many of us in the United States prepare and file our own income taxes, but because we often do so via computerized aids like TurboTax, we rarely get into the nitty gritty of income tax concepts. One such concept is the distinction between deductions and credits. Although this distinction may seem unimportant, if not understood correctly it can lead to significant missed income tax planning opportunities.
An Ordinary Family
In order to illustrate the difference between deductions and credits, let’s look at an ordinary family. Jack and Jill are married and have two children under the ages of 18 and a 2010 taxable income of $65,000. We’ll examine what happens to Jack and Jill’s income taxes in two different scenarios: an additional $5,000 deduction or an additional $5,000 credit.
In short, deductions decrease taxable income and, somewhat indirectly, the amount of income taxes owed. Although deductions are good, they will not decrease income taxes, dollar-for-dollar, in the amount of the deduction.
For example, if Jack and Jill are interested in saving money for retirement and contribute $5,000 to an IRA, it’s deductible. As a result, their taxable income will be reduced to $60,000. However, this $5,000 deduction will not decrease their income taxes by $5,000; rather, it will decrease their income taxes by $750. As a result of this $750 deduction, they will owe income taxes of $8,162.50 rather than $8,912.50.
Unlike deductions, which indirectly decrease income taxes by reducing taxable income, credits directly reduce income taxes dollar-for-dollar.
Let’s modify the example above slightly. Say Jack and Jill still have the same taxable income; however, rather than a tax deduction of $5,000, they have a tax credit of $5,000. This $5,000 credit will decrease their income taxes by $5,000. Because of the credit, rather than owing income taxes of $8,912.50, they will only owe $3,912.50.
For Jack and Jill, the difference between deductions and credits is striking: a $5,000 deduction results in income taxes of $8,162.50 while a $5,000 credit results in income taxes of $3,912.50, for a total difference of $4,250.
The Decreasing Effect of Credits and Deductions
Unless tax rates exceed 100% of a person’s income (don’t laugh; it happened in Sweden not so long ago) credits will likely always be more taxpayer-friendly than deductions. However, the advantage of credits over deductions decreases the more taxpayers earn and the higher their marginal tax rates.
Let’s look at Jack and Jill again, but modify their taxable income to be $200,000. Now that they are in a higher marginal tax bracket, the difference in the effect of deductions and credits is lessened. In the example above, a $5,000 tax deduction decreased Jack and Jill’s income taxes by $750, but now it decreases their income taxes by $1,400, an increase of $650. In contrast, however, the effect of tax credits is not altered by income tax increases: a $5,000 credit will still decrease income taxes by $5,000.
Although the distinction between tax credits and deductions may seem trivial, a good understanding of the effects of this distinction generally allow taxpayers to more effectively take advantage of tax planning opportunities as they arise and, in particular, those 2010 credits that are still available.