Tax cancellation, tax deduction and tax credit: an overview

Tax terms like “write off“, “deduction” and “credit” are often used during tax season, but many people don’t completely understand the difference. Although “write-off” and “deduction” are frequently used interchangeably, they essentially refer to the same concept: an expense that can reduce your taxable income.

However, a tax credit is an entirely different matter. This directly reduces the tax you owe, resulting in a larger refund or smaller tax bill. Understanding these differences is essential to maximizing your tax savings.

Tax write-off and tax deduction

The terms “tax deduction” and “tax deduction” mean the same thing in the context of taxes. A write-off or deduction is an expense that you can subtract from your gross income to reduce your taxable income for the year.

For example, if you are self-employed and spend money on office supplies, that cost is considered a tax deduction or write-off. If you earned $50,000 a year but spent $5,000 on business expenses, your taxable income would be reduced to $45,000 and you would pay taxes on the lower amount.

Tax credits

Unlike a tax deduction, which reduces the amount of income you have to pay taxes on, a tax credit directly reduces the amount of taxes you owe. In other words, a tax credit is a dollar for every dollar reduction in your tax liability.

THE child tax credit is one of the best-known tax credits, providing a credit of up to $2,000 per child to qualifying parents.

There are two main types of tax credits:

• Non-refundable credits: These can reduce your tax payable to zero but cannot give rise to a refund. For example, if you owe $3,500 in taxes and qualify for a $4,000 non-refundable credit, your taxes will be reduced to $0, but you will not get the $500 back.
• Refundable credits: These can reduce your tax liability below zero, thereby resulting in a refund. For example, if you owe $1,000 in taxes and qualify for a refundable credit of $1,500, you will receive a refund of $500.

How tax deductions work

Unlike a tax credit, a tax deduction reduces your taxable income, which reduces the amount of tax you have to pay.

For example, if a person is operating as a sole trader, many of their business expenses can be claimed as a deduction. Office expenses such as rent would be considered tax deductions and reduce the amount of taxable income earned.

Some common types of tax deductions include:

• Mortgage interest: If you own a home, your mortgage interest is generally deductible.
• Medical expenses: If you incur high medical expenses, you can deduct part of these expenses.
• Student Loan Interest: You can deduct up to $2,500 in interest on your student loan, depending on your income.
• Charitable donations: Contributions to qualified charities are deductible.

For example, let’s say you have taxable income of $50,000 and are eligible for deductions of $5,000. Your new taxable income would be $45,000 and you would pay taxes on this reduced amount.

The essentials

Understanding the difference between tax deductions, deductions and credits is essential to optimizing your tax return.

Write-offs and deductions reduce your taxable income, while credits directly reduce the taxes you owe. Tax credits can often provide greater savings than deductions, and some credits are even refundable, meaning you can receive a refund if your tax liability is reduced to zero.

Keep track of your eligible expenses and take full advantage of available credits and deductions to reduce your tax burden.