 Hello and welcome to the session in which we will explain the difference between tax credits and tax deductions What are tax credit and tax deduction? There are different tools different mechanism that Congress it doesn't have to be the Congress it can be the Government in that particular country they can utilize they can use they can deploy To reduce a taxpayer overall tax liability So why would the government? Create credits and deductions if they want to reduce your tax liability Why don't they just reduce your tax rate isn't that easier? Well, the reason the government uses tax credits and tax deduction is to encourage certain behavior So the government wants you to do certain things. How would what would they do? They create incentives How do they create incentives? They create what's called tax credits and tax deduction For example for education purposes if they want you to attend schools They will create either a credit or a deduction or both for example in the US We have tax credit and we have tax deductions for education. That's gonna encourage you That's gonna help you save on your taxes if you undertake this activity, which is education Also, if they want to encourage you to use alternative energy, what will they do? They will give you tax credits or tax deduction for example to buy a car like Tesla That uses alternative energy not fossil fuel or to install energy-saving equipment in your household or For family formation for example if you want to get married you want to have kids the government will give you more tax credits Now, but we need to understand what's the difference between tax credit and tax deduction because if they both serve the same purpose What is the difference between them before we proceed any further? I have a public announcement about my company farhatlectures.com Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of Lectures, multiple-choice questions, true-false questions as well as exercises. Go ahead start your free trial today No obligation, no credit card required Starting with tax deduction, what is a deduction? A deduction is an amount It's a dollar amount that you can subtract the deduct from your taxable income So your taxable income could be a certain amount a hundred thousand dollars for the sake of illustration Then you can deduct something from it Let's assume 10,000. Well, if you can reduce it by 10,000, now your taxable income is 90,000 Deduction reduces the amount of income that's subject to tax. So rather than paying taxes on the 100,000 They gave me this deduction of 10,000. So it's reducing your taxable Income. This is what a deduction is doing. It's taken a slice out of that amount that you are subject to taxation And deductions in our taxes, they can be either considered itemized deductions, which is specific expenses Which we'll talk about those later on or standard deduction, which the government gives you a standard deduction Which is a fixed amount, a standard amount. Now, how do you save on on deductions? Well, the actual saving from a tax deduction depending on something we call your marginal tax rate Now, what is your marginal tax rate? That's your highest tax rate. What would you pay on the last penny in taxes as Deduction lower your taxable income. That's the taxes you owe So if they can reduce Your taxable income, for example, you're gonna pay the most taxes on the last dollar you earned because our tax system is Progressive progressive means the more you make the more you pay Therefore the more you can shave the more you can reduce your taxable income The better off you are. So let's assume your annual income is 60,000 and you have a tax deduction of 10,000 so Generally speaking not generally speaking you earn 60,000 from your wages for some reason Let's assume the standard deduction, which is that's not the case But let's assume the standard deductions happens to be 10,000 the government gave you a standard deduction of 10,000 now Your taxable income is 50,000 so how did that 10,000 deduction saved you money on your taxes? Let's assume for the sake of illustration your marginal tax rate is 25% it means that on the last pennies you earn you have to pay 25% Well, if you were able to reduce Your taxable income by 10,000 Well, guess what because I reduced my taxable income by 10,000 I'm gonna multiply my saving by 21 25% because otherwise I would have paid taxes on that 10,000 in other words I saved 2,500 on my taxes Why because I got a tax deduction. That's what I did now. Here's what I want you to Understand about tax deduction The same tax deduction might benefit two individual people differently. What does that mean? It means if I am in a different tax bracket, let's assume I make $300,000 for the sake of illustration then I have a deduction of the same $10,000 now if my tax rate because I make more money is 35% Now my savings is 10,000 times 35% it means I saved $3,500 notice this the amount of deduction is the same for myself and this other taxpayer the 60,000 taxpayer However, the higher is your tax rate. The more is the benefit of the deduction So they hire your tax rate. So the more money you make the higher is the tax benefit of the deduction why because It's applied to the last dollar you earn and that's that's that's taxed the most Now you would learn about many many many deductions down the road in taxes We like deductions think of them as expenses something you can deduct on your taxes Don't worry. What deductions do you get? You'll have many deductions You will worry about them later on now Let's talk about tax credit because that's the other tool that they have a credit is a direct reduction in the amount of tax You owe Unlike a deduction a credits are subtracted from your tax liability Providing a dollar for a dollar reduction. What does that mean? Remember in a deduction? We said well, let's assume you made a hundred thousand you can deduct ten thousand the tax credit is different The tax credit says now compute your tax bill. So let's assume this is 90,000 and for the sake of illustration You have to pay the government You have to pay the government 30% so that's point three of 90,000 your tax bill is 27,000. That's your tax bill Okay, after you took your deduction your tax bill is 27,000 here comes the tax credit the tax credit reduces your Tax bill reduces your tax liability. Now. Let's assume for some reason or another you have tax credit of 5,000 You can reduce your tax bill by 5,000 now your taxes are 22,000 it's reducing if you have a 5,000 credit of tax credit It's reducing your tax liability dollar for dollar Remember the 10,000 when we work the 10,000 dollar example it assuming 25% tax rate Well, let's assume 30% it's only gonna reduce your tax bill by 3,000 the $5,000 tax credit This is a tax credit reduce your tax bill by exactly $5,000 for a dollar now We have to understand that tax credit Some of them are considered refundable and some of them are considered non refundable So what's the difference between the two a refundable tax credit, which is good You want it to be refundable right can result in a tax refund even if the amount is greater than the tax you owe What does that mean? It means even if you wipe up wipe all your taxes out through the credit Let's assume you owe $3,000 in taxes. That's your tax bill That's your tax bill and you have credit of 3,200 those are the credits all the credits which would learn about later Guess what because you have more credits than a tax bill if if the credit happens to be a refundable the government will give you a check For $200 because it's a refundable credit Non-refundable credit. Let's assume you have credits of 3,200 but they are non refundable Guess what the 3,000 will only bring down your tax bill to zero and the government will not give you a check The best is to look at an example just to kind of illustrate the point although I look at an example, but let's look at another example Suppose your annual income is 60,000 and the tax liability happens to be eight if you are eligible for a 3000 tax credit you would subtract so your tax bill is eight You have a credit of three now you owe $5,000 now let's assume Let's assume that this credit is refundable that this 3000 credit is refundable and let's assume your tax bill was only Was only 2000 okay, so your tax bill now we're assuming it's 2000 and you have $3,000 of credits if it's refundable What's gonna happen? The government will send you a check for a thousand dollar. This is why it's a refundable tax credit So understand the difference between refundable and non refundable now We have certain credits that are refundable and certain that are non So this is a list of non refundable credit and you can take a look at this list Don't worry. We're gonna look at each one of them separately child independent care credit lifetime credit adoption retirement So on and so forth and we have some refundable earned income credit child tax credit additional child tax credit Also, we have here non refundable portion of the American opportunity tax credit and the same credit Part of it could be refundable. We'll talk about all of those later Now from a form perspective from a form perspective The credits are tax and credit for example on your form 1040 on page 2 They're gonna have a place where you have a list of credits and there's gonna be another place For example, this is where you put your child tax credit and you'll have to fill out form schedule 88 12 and Here you have other credit called earned income credit Here you have American opportunity credit I'm just showing you where the credit goes the credit goes as payment as a reduction in your taxes and we'll work with the credits later on Also, what's gonna happen is you're gonna have a bunch of credits that are considered non refundable and this is some of them I listed some of them We're gonna go through most of them and this is schedule 3 form 1040 So you have all these non refundable credit you add them up Then you'll take them to your 1040 eventually and they will go on your 1040 as part of your Part of your credit, which is lying 31 amount from schedule 3 line 15 Now if you're looking in a different year, it could be the credit could be in a different place But overall that's the idea listing of credits, but this is the form These are the general form so in a summary what we can say tax deduction reduce your taxable income your income your wages While tax credit reduce your tax liability reduce your tax bill the amount that you have to work You can you can reduce it the actual saving from tax deduction Remember depend on your marginal tax rate two different people could have the same deduction But different effect on their savings depending on their tax rate again the higher your tax rate the more Advantages is your deduction However, tax credit provide dollar for dollars if you have a tax credit for a dollar tax credit I have a dollar tax credit. They're equal to each other. What should you do now go to far hat lectures look at additional resources? MCQs true false That's gonna help you do what to prepare for the CPA exam prepare for your accounting courses prepare for any Professional certification you are studying for enrolled agent exam. Good luck study hard invest in yourself and stay safe