Understanding Tax Deductions and Tax Credits

Tax Deductions? Tax Credits? Which one do I prefer…

Tax deductions and tax credits both reduce the amount of tax you owe, but they function differently.

Many people often mix up tax deductions and tax credits. In all cases, you would prefer one over the other, but the path to that conclusion isn’t always easy to understand.  

We are here to clear up any misunderstanding you may have. In this brief article, we will explain how each works, so you can make most of them. 

Tax Credits

A tax credit directly reduces the amount of tax that you owe. Think of it like a gift card: if you’re buying $150 worth of items at a store, and have a $50 gift card, you only need to pay $100 out of pocket. A tax credit is just like that gift card; it pays part of what you owe.

To make things more confusing, tax credits can be both refundable and non-refundable.

A non-refundable credit can reduce your tax payable to zero, but will not result in a refund if the credit exceeds the tax owed. Examples include the basic personal exemption, age amounts, and disability tax credits. For instance, if you owe $3,000 in taxes and have a $4,000 non-refundable tax credit, your tax payable becomes zero, but you won’t receive the extra $1,000 as a refund.  

A refundable tax credit can reduce your tax payable to zero, and will result in a refund if the credit exceeds total tax owed. In Canada, examples include the GST/HST Credit, the Canada Workers Benefit, and the Canada Child Benefit. For example, if you owe $3,000 in taxes and have a $4,000 refundable tax credit, you’ll receive a $1,000 refund. 

A $1,000 tax credit will save you $1,000 in taxes, regardless of your tax bracket. 

Tax Deductions 

On the other hand, a tax deduction reduces your taxable income. Instead of directly lowering your tax bill, it lowers the amount of income that is subject to tax. 

Think of a tax deduction like a discount at a store. If a jacket costs $100 and you get $20 off, you’re reducing the amount you have to pay to $80. 

If your taxable income is $50,000, and you claim a $5,000 deduction, your taxable income will now be reduced to $45,000. This doesn't mean you save $5,000 in taxes; rather, it means $5,000 less of your income is taxed. 

The actual tax saving depends on the marginal tax rate. For instance, if your marginal tax rate is 30%, a $5,000 deduction would save you $1,500 in taxes. 

How we can help

We are here to help with any questions you may have. As experts in understanding tax deductions and credits, we ensure that you maximize your benefits. We’ll make sure you AND your business stay compliant and up-to-date with tax laws, ultimately reducing your tax liability and optimizing your financial situation. 

Book a free consult here.