Tax Credits vs. Tax Deductions: Understanding the Difference

When it comes to reducing your business tax liability, it's essential to understand the distinction between tax credits and tax deductions. Both can save you money, but they do so in different ways. Let’s break it down, using real examples that business owners may encounter.

Tax Deductions
A tax deduction reduces your taxable income. The lower your taxable income, the less tax you owe. For example, if your business earns $100,000 and you have $20,000 in deductions, your taxable income becomes $80,000. The tax is then calculated based on the reduced amount.

Example of a Business Deduction:
Let’s say your business buys new office equipment for $10,000. You can deduct this expense, meaning it reduces your taxable income by $10,000. If you're in the 22% tax bracket, this deduction would save you $2,200 in taxes (22% of $10,000).

Deductions reduce your taxable income, but the actual tax savings depend on your marginal tax rate. So, higher-income business owners see more benefit from deductions because they pay at a higher tax rate.

Tax Credits
A tax credit, on the other hand, directly reduces your tax liability dollar for dollar. After calculating your total taxes, you subtract any credits to determine the final amount you owe. Tax credits are generally more valuable than deductions because they apply directly to your tax bill, not just your taxable income.

Example of a Business Tax Credit: 401(k) Start-Up Credit
The SECURE Act introduced a new tax credit for small businesses to encourage setting up retirement plans for their employees. For businesses with 100 or fewer employees, this tax credit covers 50% of the costs to start a new 401(k) plan, up to $5,000 per year for the first three years. Additionally, if you include automatic enrollment, there’s an extra $500 credit per year.

Illustration of the Impact

Let’s compare the two:

  • Tax Deduction Example:
    Suppose your business has $100,000 in income and you spend $10,000 on office supplies. If you are in the 22% tax bracket, your deduction reduces your taxable income by $10,000, and you save $2,200 in taxes.

  • Tax Credit Example:
    Now imagine you set up a 401(k) for your employees and qualify for the 401(k) start-up tax credit. You spend $5,000 to start the plan and receive a credit of $2,500 (50% of $5,000). If your total tax liability is $8,000 before the credit, the $2,500 credit reduces your tax bill to $5,500.

As you can see, while deductions reduce the income that you’re taxed on, credits directly reduce the amount of tax you owe. For many small businesses, tax credits can be a more powerful tool for minimizing their tax liability.

Questions
Understanding the difference between tax deductions and tax credits is crucial for effective tax planning. Deductions reduce your taxable income, but credits reduce your overall tax bill. Both can offer significant savings, and utilizing the right mix of deductions and credits can help ensure you're paying the lowest amount of tax possible. Always consider consulting a tax professional to make sure you're maximizing these benefits for your business. If you have any questions, please do not hesitate to contact TrueBlaze Advisors.

Read more articles from this series here:
Understanding Marginal Tax Brackets
Standard vs. Itemized Deductions: What You Need to Know
Understanding Use Tax: What it is and Why it Matters to Your Business

Understanding Capital Gains and Losses: What Business Owners Need to Know

Tax Deferred vs. Tax Exempt: Understanding the Difference in Investment Income