What is the key difference between a tax credit and a tax deduction?

The key difference between a tax credit and a tax deduction lies in how they affect an individual's tax liability. A tax credit directly reduces the amount of tax owed, effectively giving taxpayers a dollar-for-dollar reduction in their tax bill. For example, if a taxpayer owes $1,000 in taxes and qualifies for a $200 tax credit, their tax liability is lowered to $800.

On the other hand, a tax deduction lowers the taxable income, which in turn reduces the amount of tax owed but not on a dollar-for-dollar basis. Deductions are subtracted from gross income to determine the taxable income, which will then be taxed at the appropriate tax rate. For instance, if the taxpayer has $50,000 in income and $10,000 in deductions, their taxable income would be $40,000. If their tax rate is 20%, they would owe $8,000 instead of $10,000.

This fundamental distinction highlights why a tax credit can often lead to a more significant impact on a taxpayer's overall financial obligation compared to a deduction.