A tax credit and an exemption can both help reduce the amount paid in income taxes, but using very different methods. In some cases, a person may qualify for both a tax credit and an exemption, which can generally be used together to reduce a tax burden even further. The primary different between a tax credit and an exemption is that a credit reduces the amount paid in taxes, while an exemption affects the amount of annual income that can be taxed.
When examining the difference between a tax credit and an exemption, it is important to understand that they work on opposite sides of the same equation. How much income is considered taxable depends on how much money a person or household makes, less any deductions and exemptions. Once the amount owed, based on taxable income, is determined, tax credits can be applied to reduce the actual percentage of that amount an individual or household must pay back. In other words, tax exemptions help calculate the total amount of tax owed, while tax credits help reduce the total payment made.
A tax exemption is a set amount of money awarded by the government to an individual. In general, every taxpayer, and their dependent spouses or children, are allowed a specific amount that can be exempted from their income on a yearly basis. The amount that can be exempted may change annually, and may be different depending on whether the tax return is for an individual or a married couple. Most US taxpayers are eligible to take at least an individual exemption every year.
One of the major differences between a tax credit and an exemption is that nearly everyone qualifies for an exemption, whereas a tax credit is given only to certain individuals. A tax credit is usually given when the government wants to create an incentive for a beneficial behavior, such as installing solar panels on a primary residence. Tax credits are also sometimes given to people that make a relatively little, in order to help them keep more of the money they earn. Eligibility for a tax credit may be based on actions taken during the previous tax year, and may expire after a certain time period.
A tax credit helps reduce payments made to the government, or may even allow for taxpayers to receive a tax return. Once the total tax is calculated for a person or household, credits are applied to either reduce the tax payment, or create a negative balance that the government now owes the taxpayer. Though they are more selectively applied, a tax credit can be a great way to reduce taxes. Since rules about tax credits change annually, it is important to check regulations thoroughly to determine if any purchases or actions during the last year qualify for a credit.