Tax Credit, Tax Break, Tax Deduction. Is One Worth More?
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Ok, question for you. It’s tax season, but do you know the difference between a tax credit, tax deduction, tax exemption, tax break, and tax loophole?
Our tax system is so complicated that most of us don’t fully understand the distinctions. And these terms get thrown around a lot — and are even used interchangeably — which adds to the general confusion this time of year.
But the next time filing tax returns comes up in conversation, you can be the voice of clarity. After all, it’s to our collective benefit to have an understanding of how taxes work, especially when we’re talking about serious money. So here’s a quick primer:
Tax credits, deductions and exemptions are all types of tax preferences. They encourage or reward certain types of behavior seen as beneficial to society or the economy, like buying a house or an energy-efficient car. They can also give people in select groups an advantage, like parents with children.
Tax credit: A tax credit reduces what you owe dollar-for-dollar. Most credits can’t reduce your tax bill to less than zero and are known as non-refundable. The exceptions are refundable tax credits like the Earned Income Tax Credit. If you’re eligible for one of these, you can get money from the IRS even if you don’t owe any tax. So, for example, if your tax bill is $1,000 before applying a $2,000 tax credit that’s refundable, you’d get a $1,000 refund. (Here’s a complete list of available credits.)
Tax deduction: A tax deduction is an amount that you can subtract from your taxable income. So rather than pay taxes on your total income, you only pay taxes on some of it. Everyone gets to subtract something from their taxable income. They either take the so-called standard deduction — a flat dollar amount set by the IRS each year and based on your tax filing status — or they can add up individual expenses or losses that are eligible for deduction. (Here’s a list.) This is called itemizing deductions.
Tax exemption: A tax exemption is like a tax deduction, though you don’t hear the term as much these days. In 2018, the Tax Cuts and Jobs Act suspended the deduction for personal exemptions through 2025, replacing it with a higher standard deduction. The term is still often used in business, however. Some charitable organizations, for example, are exempt from paying income tax.
Tax break or tax loophole: These terms usually refer to some sort of tax benefit such as a credit, deduction, exemption or preferential tax rate.
OK, pop quiz: If you’re paying 10% on $10,000 of income, which is more valuable — a $1,000 tax credit or a $1,000 tax deduction?
If you answered tax credit, you’re right! A $1,000 tax credit is worth $1,000 whereas a $1,000 tax deduction means you’re paying 10% of $9,000 rather than 10% of $10,000, saving you $100.
So what? Sixty-four percent of people couldn’t answer that quiz question correctly in a recent Tax Foundation survey. So you’re already ahead of the game. And as mind-numbing as taxes may feel, understanding the big picture — including the lingo — can make a difference to your bottom line.
Related Reading
• Tax Truths: Elevate Your Financial IQ (Tax Foundation)
• 8 Tax Deductions You Didn’t Know You Qualified For (CBS News)
• 5 Things to Do If You’re Filing Taxes for the First Time (SoFi)
photo credit: iStock/sturti
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