Tax Credits and Tax Deductions are great! Both reduce the amount of taxes you will have to pay at tax time but there is a big difference.
Tax DEDUCTIONS reduce your taxable income while tax CREDITS reduce the amount of tax you pay.
Why is this important?
Well let’s say you want to buy a home. Your adjusted gross income is the amount that lenders will use to qualify you for your loan. They consider this number the amount of money that you actually made over the year. Tax DEDUCTIONS reduce this amount.
Tax CREDITS, on the other hand, do not affect this number. Thus, your income stays the same but the amount of taxes you pay goes down. Here’s a simple (not inclusive) example.
Say you made $50,000 and your tax rate is 20%
Some of your deductions would include interest paid out, charitable deductions, health insurance premiums paid, and business expenses. Let’s say these deductions total to $10,000.
This would bring your adjusted gross income down to $40,000 ($50,000 – $10,000). For loan approval purposes, you would be considered to have made $40,000 for the year (not $50k).
The tax you would have to pay would be $8,000 ($40,000 x 20%)
But let’s say you can get a tax CREDIT of $5,000. This means that you would have to only pay $3,000 in taxes ($8,000 – $5,000) and your income of $40,000 stays intact. (if this were a DEDUCTION, your income would go down to $35,000)
So while deductions are great and reduce your income (therefore reducing your tax due) credits are KING because they reduce the actual amount in taxes but do not reduce your income, should you need to prove that you actually have income!