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Definition of a Tax Credit

The definition of a Tax Credit is an item that reduces your actual tax. It differs from a tax deduction that reduces only your taxable income.

Definition of a Tax Credit

A tax credit is generally much more valuable than a deduction. The tax credit reduces the actual amount of tax that must be paid. A deduction, on the other hand, only reduces the taxable income. Therefore, the tax deduction is subject to the variation in the progressive tax rate. A tax credit does not depend on the tax rate and so it is of equal value to a taxpayer regardless of his income level.

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To understand this concept imagine an event that has a value of $1000 as either a tax deduction or a tax credit. If the event creates a valid deduction, it reduces the taxable income by $1000. Since the tax rate varies depending upon gross income, the amount of tax saved would depend on whatever tax rate was applicable. If the taxpayer was going to be taxed at 25%, the $1000 reduction in income would result in a savings of $1000 x .25 = $250. This figure would vary according to the tax payer’s tax rate. The tax credit results in a savings of $1000 in the same case.

Tax credits usually have some kind of social impact. They are used in the United States as well as several other countries to encourage certain activities. They are also used to grant tax relief to certain situations. The Earned Income Credit is an example of this type of credit. Its primary purpose is to grant some relief to low income workers and battle poverty by granting a credit to low income workers. It has a societal benefit of encouraging workers to work even at minimum wage jobs by making more of their earnings available to them.

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Other forms of tax credits can be used to encourage activities that benefit society as a whole. Credits for environmental improvements to a business or home are an example of this agenda based credits. The definition of a tax credit does not restrict the purpose of the credit. Tax credits can be legislated by Congress for just about any purpose that they see fit. The ability to reward certain activities by a direct credit to income taxes is a strong incentive toward any type of action.

Credits and Deductions are often confused in the taxpayer’ mind when tax preparation time arrives. It is important to understand the distinction. Dollar for dollar, the credit will always be a better deal because it is directly subtracted from the tax owed. The deduction only reduces the taxable income and is dependent on the tax rate. In the case of certain items such as medical expenses, the deductions must exceed a certain amount before they result in any savings at all. The credit will always result in a savings.

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