About this video
Sal explains how tax credits differ from tax deductions: a credit comes straight off your tax bill dollar for dollar, while a deduction lowers taxable income, so it saves only your marginal rate times its value. He also explains refundable credits (which can produce a refund), non-refundable credits, and examples like the Earned Income Tax Credit and Child Tax Credit.
You'll be able to
- explain why a $100 tax credit saves more than a $100 tax deduction.
- calculate the savings from a deduction using a marginal tax rate.
- explain the difference between refundable and non-refundable credits.
- name examples of tax credits such as the EITC and Child Tax Credit.
Key words
- Tax credit
- An amount subtracted directly from the taxes you owe, dollar for dollar.
- Tax deduction
- An amount subtracted from your taxable income, which saves you your tax rate times that amount.
- Marginal tax rate
- The tax rate you pay on each extra dollar of income.
- Refundable credit
- A credit that can be bigger than your tax bill, so the government pays you the difference.
- Earned Income Tax Credit (EITC)
- A refundable credit that rewards work and helps low-income earners.
- Child Tax Credit (CTC)
- A credit of about $2,000 per qualifying child that is partially refundable.
Transcript
- [Instructor] So let's talk a little bit about tax credits. So, it might sound similar to another word, tax deductions, but I wanna make sure that we know the difference because many people think that deductions are actually credits, and some people think that credits are deductions, but they are very, very different.
So let's say that you owe $200 in taxes. Owe $200 in taxes. Let's say you get a $100 tax credit. $100 tax credit. Versus a $100 tax deduction. So which one is going to reduce your taxes more? You could pause the video and think about that. Well, a tax credit is directly going to be taken from your taxes, so it's just gonna be $200 minus $100.
So you are going to save $100 from this tax credit. It's a one-for-one savings. Now, what about the scenario of the tax deduction? Well, this depends actually on what your marginal tax rate is. So let's say at that point, for every incremental dollar, you're paying a tax rate of, say, 30%.
So what a $100 tax deduction will do, it doesn't come straight out of your taxes, it comes straight out of your taxable income. Or another way to think about it is, at that point, for every incremental dollar, if you're paying 30% of taxes, you're not going to save $100 from a $100 tax deduction.
You're going to save 30% on this. You're not gonna have to pay the 30% taxes on this $100 because it got reduced from your income. So in this situation, you're going to save $30. So, a deduction is nice, but a credit is very, very nice. And there's even situations where the credit is so significant that you can get money back, and that depends if the credit is refundable or not.
So if you have a refundable credit, and I'll talk in a second about which credits are refundable. Well, let's say the same scenario, you owe $200 in taxes. If you have a refundable tax credit of $1,000. Well, what are you going to get? Well, then, not only are you not going to have to pay your $200, but you're actually going to get a, Uncle Sam, the government, is going to pay you back.
You're going to get a refund of $800. So, $200 you owe, that'll take care of that. And then you have another $800. So you'll get a refund of $800. And you might say, well, why do they ever do this? Well, for example, there's something called the Earned Income Tax Credit, Earned Income Tax Credit, EITC for short.
And this is an example of the government wanting to reward you for work. So if you work, you get this Earned Income Tax Credit. Now, it varies depending on the year. It varies depending on how many kids you have. It's up to, in the year 2025, it approaches $8,000 if you have three or more kids.
It starts to wind down and cap out once you get into the 60-something thousand dollar range. Let's say you have three or more kids and you get the full Earned Income Tax Credit, even if you owe less than 7 or $8,000 of taxes and you get that, you'll actually get a refund.
So one way to think about it is it's a way for the government to provide a benefit for low-income earners while also rewarding them for work. Now, if this was a non-refundable credit, all it would do is, is would take care of the $200, but you wouldn't get the other $800 left.
Now, what other types of tax credits are there? You have the Child Tax Credit, also known as the CTC, that, in current times, is about $2,000 per qualifying child. And once again, this is partially refundable, and it also ramps down as your income goes up. You have the American Opportunity Credit.
You oftentimes have credits for renewable energy. We, for example, got a tax credit when we installed solar panels, and there was a government incentive to lessen the cost or subsidize the cost of those panels, so we got a tax credit on that. So now you are armed with the main difference between tax credit and tax deductions.
Tax deductions, it lowers your taxable income, and so you have to think about what your tax rate is. Tax credits, they are dollar for dollar, but you also have to make sure that you qualify for them based on whatever the constraints are and based on what your income is.
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