From the course: Finance for Non-Financial Managers

Tax deductions and tax credits

From the course: Finance for Non-Financial Managers

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Tax deductions and tax credits

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- What is the impact of a tax deduction in our simple tax system? Let's say you make a hundred dollars. Remember, the first $50 is never taxed. The second 50 would be taxed at the 50% rate. So you pay $25 in tax. Now, let's say that of that $100 of income, you decide to spend $10 in a way that the government favors. Perhaps you spend $10 as a charitable contribution, or you spend that $10 paying mortgage interest on your home. So the government says, yeah, we want to encourage that behavior. That's a good way to spend $10. To encourage these behaviors, the government will give you a tax deduction for the $10 that you spend in this favorable way. So how does that $10 deduction enter into the payment of your taxes? Well, now you have to recompute your taxable income. You made a hundred dollars, but $10 you spent in a special way, which is tax deductible. So your taxable income is only $90. The first $50 is still tax free, and now the second $40 is taxed at the 50% rate. So you'll pay tax of $20. The $10 tax deduction reduces your income tax from $25 to $20. Now, again, what are tax deductions? They are expenditures by individuals that the government favors. Examples under the US tax system are charitable contributions, investing in your IRA, or your 401k plan, or paying interest on your home mortgage. They're also business tax deductions. If I have a business and I make a hundred dollars, but then I use $10 to pay wages to my employees or pay electricity on my building, I don't have to pay income tax on that $10 business tax deduction. Any legitimate business expense is a tax deduction. Now, let's say that you spend that same $10 of your income in a very favored way, according to the government. Maybe you spend the $10 increasing the energy efficiency of your home by putting solar panels on your roof. It is something the government really wants to encourage. In this case, the government will give you a tax credit. So how is this different from a tax deduction? Again, you compute your tax of $25 on your a hundred dollars income, but now the government says that you spent $10 of your income so well, so well, you spend it just the same as the government would have. So what the government says is you can reduce that $10 directly from your taxes. You owe us $25 in taxes. Just subtract that $10 tax credit directly. So you only have to pay $15 in taxes. The $10 tax deduction reduces my taxes by $5 when the tax rate's 50%. The $10 tax credit reduces my taxes by the whole $10. So if somebody gives you your choice of calling something a tax deduction or a tax credit, what should you choose? Yeah, you take the tax credit. Now, of course, you don't get to make this choice. Governments consider which activities they want to encourage and then decide to grant tax deductions for money spent on those things, and governments consider activities that they really want to encourage and grant tax credits for money spent on those items. Now, if you're not a numbers person, you're not alone when it comes to feeling intimidated by income taxes. But truth be told, the basic concepts behind income taxes are easy to understand. Different tax rates, different tax brackets, the difference between a tax deduction and a tax credit. We can understand those ideas. When it comes to the details of completing a tax return, all that can get tough, but our objective here has been to help us become comfortable with the terms and the concepts. Hopefully you were able to do exactly that. Now, if you want to know more about income taxes, my brother and I have prepared a two and a half hour course on income tax fundamentals, which is available, yes, ladies and gentlemen, right here in the LinkedIn Learning Library. So if you're thirsty for more income tax talk, I recommend that you visit that course.

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