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What is the Difference Between a Tax Credit and a Tax Deduction?

A W-9 form, a type of US tax form.
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  • Written By: Tricia Ellis-Christensen
  • Edited By: O. Wallace
  • Last Modified Date: 22 August 2014
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It’s important to understand the distinctions between a tax credit and a tax deduction, since they are two different ways of reducing the total taxes you will pay. When you first start deciding how much you will pay in taxes, you are allowed certain deductions, like those for each child or dependent. These deductions reduce the amount of your income that is considered taxable.

Conversely, the tax credit is taken after you have decided what portion of your income is taxable and have figured out how much tax you actually must pay. When you can take certain tax credits, perhaps like those offered for purchasing a hybrid vehicle, you deduct this amount directly from the taxes you owe. If you owe $2500 US Dollars in taxes and you have a $2000 USD tax credit, you subtract that credit directly from $2500 USD, reducing total taxes owed to $500 USD. The amount of taxes that you have paid over the year is also part of your tax credit. This amount is deducted from the total you may still owe, or that may reduce your tax burden to zero. In some cases, tax credits may mean the government owes you money, though with very few exceptions, this money cannot exceed the amount you paid in taxes for the year.

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One exception that exists on the tax credit is the Earned Income Credit available to very low-income families. In this case, the amount of Earned Income Credit you accrue can actually exceed the amount of taxes you paid, so that you get money back as a sort of help or assistance. This is a method for helping out families who are struggling financially, though the amount you are given may be relatively small.

Another more common credit that many people in the US take today is the Child Tax Credit. This is different than the standard deduction you take for caring for a dependent child. The amount is deducted directly from your tax, dollar for dollar, instead of from your income, while the deduction for caring for a child reduces your total taxable income and may place you in a lower tax bracket.

It’s a good idea to be aware of tax credits that may show up for one year only. In 2006 tax filings, for instance, US citizens could file for a one-time telephone tax credit because of overpaying taxes on telephone services. This was offered for the one year only, and those who missed it, simply missed it. They weren’t compensated by the government for this credit unless they specifically claimed it.

Many people suggest that the tax credit is more valuable than the tax deduction, since it does directly reduce the amount of taxes you must pay. Actually both tax deductions and tax credits are important, since they can both be a means of lowering your taxes. Tax credits tend to be more direct, and you should keep abreast of current tax laws to see if there are special credits for which you might qualify in each given tax year.

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Alchemy
Post 3

@ cougars- I just want to clarify a little information given by comparables. You can claim the credits if you have a felony drug conviction, you cannot claim them if the felony you were convicted of occurred while you were receiving federal financial aid. The same goes for misdemeanors as well. If your misdemeanors occurred before you were in school, you can still receive financial aid and tax credits.

This was an amendment to the Higher Education Act that was signed into law in 2006. The law loosens the previous amendment of section 485 that was signed in 1998, allowing past offenders to have access to higher education.

Comparables
Post 2

@ Cougars- There are a few federal tax credits and deductions for students. You can deduct up to $4000 in tuition costs as long as you are not filing married filing separately and you are not claimed on another person's tax return. You can also deduct interest paid through the year on qualifying student loans. This will all reduce your taxable income.

There are three credits that you can take advantage of, although you can only choose one. The American opportunity credit allows students to take a direct tax credit for certain school expenses not paid with grants or scholarships. This credit is essentially an extension of the Hope Credit; allowing more people to qualify, and extending qualifying expenses to include things like supplies and books. Finally, there is a lifetime learning credit that allows a student to take a credit for a percentage of expenses at both the graduate and undergraduate levels.

You should note that the credits for education are only available to a student who has not been convicted of a drug felony or misdemeanor.

cougars
Post 1

I always hear about the homebuyer tax credits and tax credits for energy, but I want to know what types of tax credits there are for students. I am a full time student, and I am expecting my tuition to go up next year. Can anyone tell me what types of credits there are for students?

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