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The Difference Between a Tax Credit and a Tax Deduction
A tax credit is much more valuable than a deduction, because it is subtracted after tax is computed rather than before. A simple example will clarify the difference.
Suppose that your combined income for the year was $100,000. The following table compares the effects on after-tax income between a $20,000 tax credit and a $20,000 deduction.
Value of a Credit Versus a Deduction
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CREDIT
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DEDUCTION |
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income
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$100,000
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$100,000
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-deductions
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0
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$20,000
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----------
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-----------
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-----------
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= taxable income
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$100,000
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$80,000
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tax
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$26,260
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$22,400
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- credit
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$20,000
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0
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---------
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---------
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= final tax
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$6,250
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$22,400
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AFTER TAX INCOME
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$93,740
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$57,600
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tax credit cost
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$12,000
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net
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$81,740
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$57,600
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difference +
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$24,140
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This example illustrates the magnitude of the difference between a credit and a deduction. As you can see, a tax credit possesses more power for retaining income than a deduction.
With the rewrite of the tax code in 1986, Congress removed most of the significant tax credits -- Section 29 being a notable exception. However, Section 29 credits are only available through the year 2002.
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