What Is a Tax Credit vs Deduction? Difference & Calculation
Federal tax credits and deductions both reduce the amount of tax you owe on your tax return, but the way the tax savings is calculated is very different. Tax deductions reduce the amount of your taxable income, whereas tax credits are directly applied against the tax you owe. Credits can reduce the amount of tax you owe or increase your tax refund, and some credits may give you a refund even if you don’t owe any tax.
Tax Savings
A $1,000 tax credit will save you $1,000 in tax, 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 in tax.
A $1,000 tax credit will save you $1,000 in tax, 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 in tax.
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Determining Your Marginal Tax Rate
The marginal tax rate is the rate that a taxpayer pays on the next dollar earned and is commonly referred to as “your tax bracket.” The federal marginal tax rate for businesses and individuals increases as income increases, which 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 on 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 went into effect on January 1, 2018, with the passage of the Tax Cuts and Jobs Act but are adjusted annually for inflation. The rates are shown in the table below.
2022 Marginal Tax Rates
Single | Head of Household | Married Filing Jointly | Married Filing Separately | |
|---|---|---|---|---|
10% | $0 to $10,275 | $0 to $14,650 | $0 to $20,550 | $0 to 10,275 |
12% | $10,276 to $41,775 | $14,651 to $55,900 | $20,551 to $83,550 | $10,276 to $41,775 |
22% | $41,776 to $89,075 | $55,901 to $89,050 | $83,551 to $178,150 | $41,776 to $89,075 |
24% | $89,076 to $170,050 | $89,051 to $170,050 | $178,151 to $340,100 | $89,076 to $170,050 |
32% | $170,051 to $215,950 | $170,051 to $215,950 | $340,101 to $431,900 | $170,051 to $215,950 |
35% | $215,951 to $539,900 | $215,951 to $539,900 | $431,901 to $647,850 | $215,951 to $323,925 |
37% | $539,901 or more | $539,901 or more | $647,851 or more | $323,925 or more |
A small business owner with taxable income of $250,000 on their Married Filing Joint 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 X 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 credit. The tax benefit of a tax deduction depends upon the tax rate of the taxpayer.
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 paid 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 X Marginal tax rate (MTR)
Example: Kim has an MTR of 25% 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 25% marginal tax rate, as shown below:
$1,000 X 25% = $250
Calculating the Tax Deduction Equivalent
Tax deduction equivalent = Tax credit / MTR
Example: Kim has an MTR of 25% and is eligible for a $250 tax credit. What is the minimum tax deduction that Kim would be willing to accept instead of the tax deduction?
You can calculate this by dividing the tax credit by the marginal tax rate, as shown below:
$250/25% = $1,000
Examples of Business Tax Credits vs Deductions
Business Tax Credits | Business Tax Deductions |
|---|---|
Work Opportunity Tax Credit | Ordinary and necessary business expenses |
Credit for Small Employer Health Insurance Premiums | Salaries & wages paid |
Credit for Employer-provided Childcare | Retirement contributions to employee plans |
Empowerment Zone Employment Tax Credit | Charitable contributions |
You can learn about all of the available business tax credits on the IRS website.
Frequently Asked Questions (FAQs)
Is a tax credit better than a tax deduction?
Yes, if the amounts 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 provide a benefit 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 $100. Nonrefundable tax credits cannot exceed the amount of your total tax liability. While they can reduce your total tax liability down to $0, they never create a negative tax liability.
Bottom Line
While the result of tax deductions and credits may be the same, such as 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 tax incentives you may wish to explore for your small business.
