Different countries have different tax laws and have different rate of ‘tax deduction' and different rules for ‘tax credit' that reduces total annual tax payable, by the amount of ‘tax credit' a person is eligible for. Tax deduction in effect reduces your total income whereas tax credit reduces your total tax burden. So we can differentiate between the two in many ways some of which are described below.
1. Tax deduction is done in a number of ways like tax deduction at source by way of deducting tax, prior to payment of salary, payment of winnings from lottery, gambling payment or payment to a contractor for his services etc. So the tax is essentially deducted by payment authority, which is paying you. A case in example is your employer. Tax credit is allowed only by the state through its income tax department as per income tax law of the concerned country.
2. Tax deducted from your income automatically turns into a part of overall tax credit at your hands, which you are eligible to adjust as deduction from the total amount of tax payable in a particular financial year while submitting annual returns.
3. Taxes are deducted at various rates depending on income slabs, payment amount etc whereas tax credits are fixed amounts.
4. All the taxes deducted become tax credit at your hands while all the tax credits are not income deductible. For example if you donate a sizable amount to charity organizations which do not have profit motive, then a percentage of such donation may be claimed as tax credit in tax returns. So is the case with home loan interest, educational loans or expenditures etc.
5. Tax credit received as a consequence of lowering your annual gross total income for donations made, certain interests paid and even certain expenditures made, in effect increases your income by refunding you the amount of tax credit you get from such lowering of gross total income. This is a sort of state benefit you get back through the tax refund system of the state.
6. In most countries self employed professionals, businessmen have to pay advance taxes depending on their projected annual income. Once such advance tax is deposited with the treasury, the amount automatically becomes a tax credit at the hands of the individual making such payment.
7. Whereas tax deduction is not refundable, tax credit may become refundable. For example a bank deducts tax on interest payment made to an individual on his deposits and hands him over the tax credit certificate. If the individual does not have taxable income or his total tax payable is less than the tax credit, then he gets full or a part of the tax credit as refund, in effect increasing his total income.
How much income tax you have to pay is determined by your income. To pay the least amount of taxes, you want to take applicable tax deductions to reduce your taxable income and tax credits to reduce your tax bill.
Tax credits are typically given for educational purposes, low income or having dependents. The amount of the credit is deducted from your tax liability and produces a significantly higher bottom-line reduction than a deduction.
Tax deductions reduce your taxable income, which is the amount the government uses to determine how much tax you should pay. Some deductions can be taken only if you itemize.
Qualifying for tax credits and deductions
It is important to note that not everyone qualifies for certain tax deductions and credits. If you make more than a certain amount of money, some credits and deductions, such as for savings accounts, Earned Income Credit and other tax lowering credits and deductions, are not available to you. There are worksheets available to help you determine whether or not you can take a certain tax credit or tax deduction.
Refundable VS Non-refundable Credits
Refundable credits are credits that can be taken in full, even if they exceed the amount that you owe the government. The Earned Income Credit is one example. Non-refundable credits are credits that cannot reduce your tax liability beyond zero. If a non-refundable credit is more than what you owe in taxes, you can only take up to the amount owed.
Some common deductions that you can take without having to itemize are deductions for retirement contributions, student loan interest, capitol losses and business expenses.
Common Tax Credits
The Child Tax Credit, Adoption Credit, Child and Dependent Care Credit, First-Time Homebuyer Credit and The Hope or Lifetime Learning credit are common tax credits, foreign income credit etc.
1) Tax deduction is that part of taxes which are already paid as tax deducted at source or deposited as advance tax. Tax credit is the tax already deposited with the state treasury plus state benefit to its citizen paid back through its tax assessment system.
2) Tax deduction lowers the income; the tax credit lowers the tax burden
3) Taxes are deducted at various rates depending on income slabs, payment amount etc whereas tax credits are fixed amounts.