Tax Deductions vs. Tax Credits—Crucial Difference Explained

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I am always amazed at how many people don’t know the difference between a tax deduction and a tax credit. It’s actually quite simple. As am I, so I’m the perfect guy to explain this. A tax deduction reduces the amount of income on which you are taxed. The tax deduction doesn’t come directly off your taxes as the name would imply, but again, off your taxable income.

Now, by coming off your taxable income, it will decrease the tax you owe but by how much? By the amount of the deduction times your marginal tax rate. See our previous video if you can stand watching me twice in one day. Oh wait, hope I changed shirts. An example: Mo contributes $2,000 to her RRSP. That’s a $2,000 tax deduction.

If her margin rate is 40%, that saves her $800 in tax. Clearly the value of a tax deduction depends on your tax bracket. Higher income equals bigger benefit per dollar deducted. A tax credit, on the other hand, is a direct reduction of the taxes you owe. It comes off your final tax bill dollar for dollar.

Your marginal tax rate is irrelevant. Example: You calculate, you owe $9,000 in tax but you have a $1,000 tax credit for medical expenses. So you’d only owe $8,000. Knowing this, what would you rather have? A $5,000 tax deduction or a $5,000 tax credit? Tax deduction! Mo, put down your beer and let’s go through this for the fourth time.