Which is better, a tax credit or a tax deduction?

Photo courtesy of alterna

 

WARNING: This post contains math.

This is one of those posts that is a challenge to write. Since everyone is in different places and with different levels of financial literacy, I can’t expect everyone to have the same level of understanding on certain topics.

So this post is going to be totally obvious to some people, and totally non-obvious to others. If you already know all about this topic, then no worries, I’ll see you next time!

For everyone else, let’s talk about taxes.

So, um, what actually is tax anyway?

Despite all the chatter about how difficult taxes are to determine (and they are), the theory behind taxes is actually pretty straightforward: you calculate how much you made, adjust it in some way, and then operate a formula on this number to figure out how much tax you owe. As you’ve likely been paying tax all year, this calculated amount is compared against what you actually paid, and you either pay more to make it square up, or you get money back.

That’s it, really. The devil is, of course, in the details.

Okay, so what’s my tax?

Let’s say you have an income of $50,000 (not too far away from the median household income). This means that your marginal tax rate is currently 25%, but your average tax rate will be 11.44% because of the progressive tax system we have in place. (If you didn’t know, your marginal tax rate is equal to the “tax bracket” you’re in.)

For (over-)simplification, let’s say there’s nothing to adjust here. So $50,000 × 11.44% = $5,720 in tax, meaning that your net is $44,280.

A $1,000 tax credit

Now, let’s do some give backs.

Say I give you a $1,000 tax credit. (You’re welcome.)

A tax credit is a net reduction in the actual taxes owed. So if you owed $5,720 in taxes, you would now owe $5,720 – $1,000 = $4,720 in taxes, making your net equal to $45,280.

A $1,000 tax deduction

Now, instead, I take away your tax credit, and give you a $1,000 tax deduction instead.

A tax deduction reduces the amount of income that is subject to tax. So this means that your “adjusted income” now is $49,000. With a new average tax rate of 11.16% (again, it’s a progressive tax system, so the rate always changes), you would now owe $49,000 × 11.16% = $5,468 in taxes, with a new net of $44,532.

So the $1,000 tax credit saves you $1,000. The $1,000 tax deduction saves you…$248.

From this we can make two very obvious determinations: tax credits are very different from (and way better than) tax deductions.

It’s actually way simpler

Actually, if we were more precise with the calculation, we’d have gotten $250. What’s significant about $250? It’s equal to the $1,000 amount when subject to the marginal tax rate (in this case, 25%).

From this, we can deduce one very important fact: the amount saved through a tax deduction is equal to the tax deduction multiplied by the marginal tax rate.

So a $5,000 tax deduction in a 25% tax bracket means a $1,250 savings. A $10,000 tax deduction in a 28% tax bracket means a $2,800 savings. You get the idea.

And no matter how you swing it, a tax deduction will never be better than a tax credit.

So as you explore your taxes (which is tough, since taxes are often the very opposite of simplicity), keep in mind that when a “tax deduction” is touted, it’s going to result in a savings equal to a fraction of the actual amount calculated. That’s good, but not great. Find the tax credits where you can.

(Calculations of average tax rate were done with this calculator.)

 

Mike Pumphrey

Mike Pumphrey

I'm the founder and author of Unlikely Radical, a site to help people succeed with money, achieve their goals, and live intentionally.

I offer a free phone consultation to anyone who is interested in changing their financial narrative. Are you ready? Click here for details.
Mike Pumphrey
Posted on January 25, 2016