Great question! A tax credit lowers your tax bill dollar for dollar. If it is a refundable credit, such as the Earned Income Credit and the Hope education credit, it can also result in a refund when you owe no tax. The deduction reduces your taxable income, which is amount on which you pay taxes. Its value depends on your tax bracket. If you are in the 10% tax bracket, a $1000 deduction saves you $100. But a $1000 credit could save you $1000, no matter what tax bracket you are in. And a $1000 refundable tax credit would result in a $1000 refund, even when you owe no taxes and had no withholding.
One of the best places to see these distinctions in practice is by comparing the current tax breaks for paying college tuition. There are currently three types of tax breaks, a tuition deduction, a Hope credit and a life-long learning credit. The tuition deduction reduces taxable income, the life-long learning credit reduces tax, but the Hope credit is a credit with a refundable feature.
Let’s assume we have a student, single, who in 2011 made $20,000 in wages and paid $6,000 in college tuition. For clarity, let’s assume he had no tax withhold on these wages. Remember, the student is out $6000 in each of these scenarios. Here are the differing results:
Tuition Deduction: Owes $653
Life-long learning credit: Owes $0; Refund $0
Hope Credit (a refundable credit), even though no income tax was withheld from the wages: $1000 refund
As you can see, the credit results in $1653 less tax on the same $6000 outlay. If the student had earned $22,250, the tax would have been $1900 less with the refundable credit.
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