by Alysa Dudley

Created on: May 10, 2010   Last Updated: August 25, 2010

“First time buyers receive a tax credit.”  “Donations to our cause are fully tax deductible.” What’s the difference?  How do they effect your pocketbook?

Most Americans have to pay income taxes.  The US government takes a percentage of your income each year to use for a variety of government expenses.

There are times, however, when the government wants to encourage certain types of spending.   People making these expenditures end up paying fewer taxes.

In brief, this is why most employed people file tax returns.  A certain amount of money is automatically taken out of paychecks for income taxes.  The information provided in a tax return determines if the amount removed from a paycheck needs to be adjusted.  People who have paid too much in taxes receive a refund,  while those who didn’t pay enough owe money to the government.

Tax deductions may be given for a variety of expenses such as interest paid on loans, charitable donations, and tax preparation fees.  The amount of qualified tax deductible expenses is subtracted from income.  People owe taxes based on a percentage of their income; if income is reduced, the amount of taxes owed is reduced.

A tax credit, on the other hand, is an amount subtracted directly from the amount of taxes people owe.  For instance, to encourage people to buy their first home the government may offer a tax credit.

EXAMPLE - THE EFFECTS OF A TAX DEDUCTION*:

Let’s say a family has income $50,000 and is in the 25% tax bracket.  Without any adjustments they would owe income taxes totaling $12,500 (25% of $50,000).

The family donates $1,000 to charities over the course of the year.  Therefore $1,000 is deducted (subtracted) from income and income taxes are owed on only $49,000 ($50,000  minus $1,000).

The result is they now owes $12,250 (25% of $49,000) in income taxes.  Bottom line, a savings of $250 ($12,500 originally owed minus $12,250 now owed).  So, for every $1,000 paid for tax deductible items, taxpayers in the 25% tax bracket owe $250 less in taxes than they would have owed without the deduction.

EXAMPLE OF THE EFFECTS OF A TAX CREDIT*:

Now take the same family earning $50,000, in the 25% tax bracket, and owing $12,500 in taxes if there were no adjustments.  Let’s say they receives a $1,000 tax credit for buying a home for the first time.

This $1,000 is subtracted from the amount of taxes the family owes.  They now owe $11,500 in taxes ($12,500 owed minus the $1,000 tax credit). The complete amount of a tax credit – regardless of tax bracket – goes into the pockets of the taxpayer.


Tax credits and tax deductions both reduce the amount an individual owes in income taxes.  They do this in different ways, but each one has a positive effect on the pocketbooks of taxpayers.


*The numbers used in these examples is for the purpose of illustration only.

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