Join Jim Stice for an in-depth discussion in this video Tax deductions and tax credits, part of Finance for Non-Financial Managers.
- So let me ask you a question. Which would you prefer, a tax deduction or a tax credit? Well, by the end of this chapter, hopefully you'll be able to answer that question. Now, recall in our previous example we took our taxable income and multiplied it by our tax rate to determine how much in tax we owed. Well what's the impact of a tax deduction in our simple tax system? Let's again assume we made $100. Remember the first $50 is never taxed. The second $50 would be taxed at the 50% rate, so you're going to pay $25 in tax total.
Now, let's say of that $100, you decide to spend $10 in a way that the government favors. Perhaps you spend that $10 as a charitable contribution, or you spend that $10 paying mortgage interest on your home. So the government says, yep, we want to encourage that behavior. That's a good way to spend $10. Then you're going to get a tax deduction for that $10. So how does that tax deduction enter into your payment of taxes? Well now you have to compute your taxable income.
You've made $100, but $10 of that was spent in a special way, which is tax deductible. So your taxable income is only $90. The first $50 is still tax-free. Now the second $40 is taxed at the 50% rate. So you're only going to pay $20 in tax. So you see here that the tax deduction of $10 reduces your income tax from $25 to $20 after you subtract the tax deduction.
The effect is that tax deductions reduce your taxable income. Again, what are tax deductions? They're expenditures by individuals that the government favors and wants to encourage. Now, if I have a business and I make $100, but I then use $10 of that to pay wages to my employees or pay electricity on my building or pay property taxes, these are tax deductions. Any legitimate business expense is going to qualify as a tax deduction and reduce my taxable income, and as a result, reduce my taxes.
Now, let's contrast a tax deduction with a tax credit. In the case of a tax deduction, remember that that reduced our taxable income. What's the difference between a tax deduction and a tax credit? Well a tax credit directly reduces your taxes. Let's go back to our same example. You make $100. In our system, the first $50, you pay no tax. The second $50, you pay the rate of 50%. So you are going to end up again, paying $25 dollars in taxes.
That's great. Now let's say that you paid $10 of those dollars in a very favored way, according to the government. Maybe you spend the $10 increasing the energy efficiency of your home. You put solar panels on the roof. You did something that the government really wants to encourage. In this case, they're not going to give you a tax deduction. They're going to give you a tax credit. So how does a tax credit differ from a tax deduction? When you compute your tax, remember we're paying no tax on the first $50.
On the second $50, our tax rate is 50%. So you're going to owe 50% of that $50, or $25. But if the government says, we're going to give you a tax credit on that $10 expenditure, what they're going to allow you to do, is to reduce your $25 in taxes down to $15. A tax credit directly reduces the amount of taxes you owe. So, which is better, the tax deduction or the tax credit? Well, we see that the $10 tax credit reduced my income taxes from $25 down to $15.
If it was a tax deduction, it reduced my taxes from $25 down to $20. The tax deduction reduces my taxes by $5. So, if somebody gave you your choice, if you want a $10 tax deduction or a $10 tax credit, you show them how wise you are. You take the tax credit. When it comes to income taxes, they can make even the stoutest of hearts a little nervous. So if you're not a numbers person, you're not alone when it comes to income taxes. But truth be told, the basic concepts behind income taxes are easy to understand.
Different tax rates, different tax brackets, the difference between a tax deduction and a tax credit, we can understand those ideas. When it comes to the details of completing a tax return, that can get tough. But our objective here has been to help us become comfortable with terms and concepts. Hopefully, we were able to do exactly that. If you want to know more about income taxes, my brother and I have prepared a two and a half hour course on Income Tax Fundamentals. If you finish this chapter and you're thirsty for more, I would recommend you visit that course.
- Interpret financial reports and make decisions based on available data
- Manage inventory and receivables
- Create an accurate budget
- Cost a product or service
- Analyze customers
- Understand your income taxes
- Communicate your contribution to the bottom line