The difference between a tax deduction and a tax credit

By | December 6, 2010

income and tax creditsI was asked the following question via e-mail the other day:

Hey Fletch,

Forgive my ignorance, but you keep calling Section 179 a tax deduction, while you called the ITC a “tax credit”. What is the difference (if any)?

 

 

Good question – a lot of people get confused by this, as they are definitely different. Here’s how they both break down:

A Tax Deduction (like Section 179) is deducted from the total income you get taxed on. In other words, you pay tax on income. A tax deduction reduces the income you pay tax on.

A Tax Credit does not affect the income you pay tax on, but comes right off the tax owed.

To further illustrate the difference, let’s show the difference on an equal number. Here’s how a $5,000 tax deduction and a $5,000 tax credit affect a $100,000 taxable income (assume a 25% tax rate).

As you can see, in equal amounts, a tax credit usually has a little more bang. However, it is rare to see substantial tax credits, while it’s quite common to see substantial tax deductions. For example, using Section 179, it’s pretty easy to hit six figures in deductions.

I don’t want anyone to think one is “better” than the other, because they aren’t – you should be taking advantage of every tax deduction and tax credit available to you. This means the ITC (if it ever comes back), and, of course, Section 179. Which brings me to:

 

My Section 179 Addendum

This is an addendum I’ll be adding to my posts for the rest of the year. That’s because it’s getting later in the year, and Section 179 for 2010 ends soon. If you want that new piece of equipment, and also want to take advantage of the new, higher limits, NOW is the time.

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