Direct Tax Category Interview Question: Tax Credit vs. Tax Deduction

When it comes to personal income tax, understanding the distinction between tax credits and tax deductions is crucial.

Tax Credit

A tax credit is a direct reduction in the amount of tax owed. It is a dollar-for-dollar reduction in the actual tax liability. For example, if you have a $1,000 tax credit, your tax liability will be reduced by $1,000.

Tax Deduction

On the other hand, a tax deduction reduces the amount of taxable income on which the tax is calculated. It does not directly reduce the tax liability but rather reduces the amount of income that is subject to tax. For example, if you have a $1,000 tax deduction and your tax rate is 20%, your tax liability will be reduced by $200.

In summary, tax credits reduce the actual tax liability, while tax deductions reduce the taxable income on which tax is calculated. Both can help reduce the overall tax burden for individuals.