As a general rule, a tax deduction is a dollar amount subtracted from a taxpayer's adjusted gross income, while a tax credit is a dollar for dollar reduction in the amount of tax owed. Deductions reduce the taxpayer's taxable income, while credits reduce the tax liability that is calculated by applying a percentage rate to the taxpayer’s taxable income.
For example, if a taxpayer has an adjusted gross income of $50,000 and a tax deduction of $10,000, the taxpayer's taxable income will be reduced to $40,000. If the taxpayer is in a 25% tax bracket, the tax owed would be $40,000 x 0.25 = $10,000. On the other hand, if a taxpayer has a tax credit of $5,000, the tax owed would be reduced by the full amount of the credit to $5,000, regardless of the taxpayer's taxable income.
There are limitations and exceptions to both tax deductions and tax credits. For example, some tax deductions are subject to individual and/or itemized deduction limits, phaseouts, or other restrictions. Some tax credits are non-refundable, meaning that if the credit exceeds the taxpayer's tax liability, the excess cannot be refunded, while other credits are refundable or partially refundable. Furthermore, the availability of certain deductions or credits may depend on the taxpayer's income level, filing status, and other factors.
Therefore, taxpayers should carefully evaluate the potential benefits and limitations of both tax deductions and tax credits when filing their tax returns. It is always advisable to consult with a licensed tax professional for specific advice on tax planning and preparation.
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