Do you know the difference between a tax credit and a tax deduction? If not then this is the article for you! It’s important to know the difference so that you can make informed decisions. No need to be confused any longer about these financial terms.
When something is tax deductible, like a charity donation or 401k contribution, it means that you do not have to pay income taxes on the money you spent. For example, let’s say you are single and have a taxable income of $45,000. You would owe $7,375 in taxes. Now let’s say you decide to put $5,000 into a traditional IRA. Contributions to a traditional IRA are tax deductible. So you don’t have to pay income taxes on that $5,000. This brings your taxable income to $40,000 and you now owe $6,125 in taxes. You put $5,000 into your IRA but it only cost you $3,750 because it was tax deductible.
When the government offers a tax credit on an item you actually get the entire purchase price (up to the credit amount) back at tax time. Let’s say you qualify for the $8,000 Homebuyers Tax credit. That means you get $8,000 off your tax bill. The government is basically giving you $8,000. Even if your total tax bill is less than $8,000 you still get the full $8,000 back. So if you owed $6,000 in taxes this year and qualified for the $8,000 tax credit then you get back everything you paid PLUS $2,000. This is true of all tax credits, I’m just picking on the Homebuyers one.
And there you have it. Let me know if you have any questions.