Question

Explain in your own words the difference between a tax credit and a tax deduction. Which one of the two is preferable? Please, include an example with your answer.

Answer 1

Tax credit directly lowers the amount you owe to the revenue service or tax department where as the tax deduction reduces the amount of your income which is subject to the taxation.

Let’s assume that your annual income subject to taxation is $100,000 and you fall within 25% tax category so your tax liability would be 100,000 * 0.25 = 25,000, now let’s say you have tax credit of $10,000 so your net tax liability would be 25000 – 10000 = 15000

Now assume that you have the same annual income but you paid 10,000 in charity which can be deducted for taxation purpose, so now your tax liability would be

= (100000 – 10000) * 0.25 = 22,500

So, tax credit is a preferable thing because it directly reduces the net tax liability due whereas the tax deduction reduces the income level which is subject to taxation.