Federal tax credits and deductions both reduce tax owed, but each provides tax savings in a different way. Tax deductions reduce the income subject to tax. Tax credits reduce the tax owed on the income and, in some instances, may result in a refund even when no tax is owed.
A $1,000 tax credit will save you $1,000 in taxes, whereas a $1,000 tax deduction will decrease your taxable income by $1,000. The actual tax savings from the $1,000 tax deduction depends on your tax rate. For instance, if your marginal tax rate is 25%, then a $1,000 tax deduction will save you $250.
Determining Your Marginal Tax Rate
You must determine your marginal tax rate to compare the tax savings between tax deductions and tax credits. The marginal tax rate is commonly referred to as your “tax bracket.” The federal marginal tax rate for taxpayers increases as income increases. This is known as progressive taxation. Low-income earners are taxed at a lower rate than higher-income earners.
Small business owners who are either self-employed, partners, or S corporation (S-corp) shareholders pay tax on their business income through their individual tax returns. Therefore, the marginal tax rate on their business income is determined by the total taxable income shown on their individual tax return. The current marginal tax rates are shown in the table below and reviewed annually by the IRS for inflation adjustments.
2024 Marginal Tax Rates
2024 Tax Brackets and Federal Income Tax Rates by Filing Status | ||||
|---|---|---|---|---|
Tax Rate | Single | Head of Household | Married Filing Jointly | Married Filing Separately |
10% | $0 to $11,600 | $0 to $16,550 | $0 to $23,200 | $0 to $11,600 |
12% | $11,600 to $47,150 | $16,550 to $63,100 | $23,200 to $94,300 | $11,600 to $47,150 |
22% | $47,150 to $100,525 | $63,100 to $100,500 | $94,300 to $201,050 | $47,150 to $100,525 |
24% | $100,525 to $191,950 | $100,500 to $191,950 | $201,050 to $383,900 | $100,525 to $191,950 |
32% | $191,950 to $243,725 | $191,950 to $243,700 | $383,900 to $487,450 | $191,950 to $243,725 |
35% | $243,725 to $609,350 | $243,700 to $609,350 | $487,450 to $731,200 | $243,725 to $609,350 |
37% | $609,350 or more | $609,350 or more | $731,200 or more | $609,350 or more |
A small business owner with a taxable income of $250,000 on their Married Filing Jointly tax return has a marginal tax rate of 24%. If they receive a tax deduction of $1,000, their taxable income will be reduced to $249,000, and they will save $240 in tax ($1,000 × 24%).
How to Calculate the Equivalent Tax Credit or Deduction
To calculate the equivalent tax credit or tax deduction, you must first know your marginal tax rate. However, a tax credit provides the same tax relief regardless of the taxpayer’s marginal tax rate.
Whether to provide a tax credit vs deduction for a new tax incentive is often a hot debate. A tax credit favors low-income taxpayers in that they will receive the same amount of tax savings as high-income taxpayers, even if they pay far less in total tax. Meanwhile, a tax deduction favors high-income taxpayers because they will receive a larger tax benefit since they have a higher marginal tax rate.
Calculating the Tax Credit Equivalent
Tax credit equivalent = Tax deduction × Marginal tax rate (MTR)
Example: Kim has an MTR of 24% and is eligible for a $1,000 tax deduction. What is the minimum tax credit that Kim would be willing to accept instead of the tax deduction?
You can calculate this by multiplying the $1,000 tax deduction by the 24% marginal tax rate:
$1,000 × 24% = $240
Calculating the Tax Deduction Equivalent
Tax deduction equivalent = Tax credit/MTR
Example: Kim has an MTR of 24% and is eligible for a $240 tax credit. What is the minimum tax deduction that Kim would be willing to accept instead of the tax credit?
You can calculate this by dividing the tax credit by the marginal tax rate:
$240 / 24% = $1,000
Examples of Tax Credits vs Deductions
Business Tax Credit Examples | Business Tax Deduction Examples |
|---|---|
Work Opportunity Tax Credit | Ordinary and necessary business expenses |
Credit for small employer health insurance premiums | Salaries and wages paid |
Credit for employer-provided healthcare | Retirement contributions to employee plans |
Empowerment Zone Employment Tax Credit | Charitable contributions |
(Source: IRS.gov)
Individual Tax Credit Examples | |
|---|---|
Clean Vehicle Tax Credits | Student loan interest |
Home Energy Credits | Standard deduction |
Earned Income Tax Credit | Bad debt deduction |
American Opportunity Tax Credit | Home mortgage interest |
Lifetime Learning Credit | Medical expenses over 7.5% of adjusted gross income |
Adoption Credit | IRA contributions |
Child Tax Credit | HSA contributions |
Dependent Care Credit | Charitable donations |
(Source: IRS.gov)
What Is the Commercial Clean Vehicle Credit and Who Qualifies?
What Is the Work Opportunity Tax Credit (WOTC)?
7 Small Business Tax Credits That Your Company May Qualify For
Why Deductions Favor High-income Taxpayers
1. High-income earners have higher tax rates
Tax deductions reduce the amount of income that is subject to tax. Since the taxpayer’s tax rate determines the deduction amount, wealthier taxpayers with higher tax rates derive a larger benefit. For example, a $5,000 deduction for someone in a 10% tax bracket is only worth $500 ($5,000 × 10%). The same deduction would be worth $1,750 to someone in the 35% tax bracket.
2. Utility of itemized deductions
The IRS allows most US citizens to reduce their taxable income by a specific amount that is designated every year. This amount is known as the standard deduction. Taxpayers may choose to reduce their income by this standard deduction or by the sum of itemized deductions, depending on which is more beneficial.
Itemized deductions represent specific expenditures the taxpayer made during the year that are allowed as deductions by the IRS. However, to deduct expenses, you have to have enough cash during the year to make the expenses in the first place. As such, lower-income taxpayers (under $200,000 per household) tend not to take advantage of itemized deductions.
Frequently Asked Questions (FAQs)
Is a tax credit better than a tax deduction?
Yes. If the amount of the tax credit and tax deduction are the same, a tax credit is better than a tax deduction. For example, a $100 tax credit reduces your tax liability by $100, whereas a $100 tax deduction only reduces your tax liability by $100 times your marginal tax rate.
What are refundable vs nonrefundable tax credits?
There are two forms of tax credits: refundable and nonrefundable. Refundable tax credits are beneficial even if you don’t have a tax liability. In other words, if your total tax liability is $300, and you receive a $400 refundable tax credit, the IRS will pay you a related refund of $100. Nonrefundable tax credits cannot exceed your total tax liability. While they can reduce your total tax liability to $0, they never create a negative tax liability.
Why are some allowable IRS deductions not useful in reducing my tax?
Certain deductions such as home mortgage interest, charitable donations, and medical expenses are only deductible if you itemize deductions on your tax return. If the total amount of the allowable deductions is less than the standard deduction ($14,600 for single taxpayers in 2024), the allowable IRS deductions won’t be useful in reducing your tax.
What is a tax credit phase-out?
The IRS only makes certain credits available to taxpayers below a certain income level. As a taxpayer’s income approaches the designated income level, less and less of the credit is allowed until, ultimately, the taxpayer arrives at the income limit set by the IRS and none of the tax credit is available to them.
Bottom Line
While the result of tax deductions and credits may be the same (you pay less in taxes) and the amount of the tax savings is different, knowing the differences between tax credits and tax deductions can help you understand the tax savings for various small business tax incentives.
