Which Is Better — Tax Credit or Tax Deduction?
Why it is important to understand the difference between a tax credit and a tax deduction
“Like mothers, taxes are often misunderstood, but seldom forgotten.’’ — Lord Bramwell
I’m ashamed to admit it. For many years, even after I got my licence to practice as a Chartered Accountant and even after starting my firm, I did not know the difference between a tax credit and a tax deduction.
Somehow, I forgot quite a bit of what I learned in my tax course during university days or things I studied to prepare for my professional exams.
It appears that everything I know today about taxes, I learned during the years I’ve been running my business. And it never ends, I continue to learn new things everyday.
So, what the heck is a tax credit? And a tax deduction?
Before I examine the difference between a tax credit and a tax deduction, it is important to understand that income tax is based on your taxable income, not your total income.
To get to your taxable income, the Income Tax Act allows you to deduct various amounts from your income to arrive at your taxable income. In addition to this, there are many credits that you can use to reduce the taxes payable.
While a few people may be familiar with tax credits and tax deductions, most people don’t understand the difference between these two terms. More importantly, I find that taxpayers don’t always take advantage of the various tax credits and deductions that are available to reduce their income taxes.
As a result, they end up keeping less of their money. So what are tax credits and tax deductions? And what are the differences between a tax credit and a tax deduction, and why does it matter?
Tax Deductions
“Few of us ever test our powers of deduction, except when filling out an income tax form.’’ — Laurence J. Pete
Tax deductions reduce your taxable income. They are allowable expenses and adjustments you can claim to reduce your taxable income. This means that if you earned $100,000 in income and had $10,000 in expenses, your taxable income would be $90,000.
The tax rates will then be applied to this $90,000 to arrive at your taxes payable. Tax deductions reduce the taxes owed by your marginal tax rate.
Examples of allowable deductions include contributions to your Registered Pension Plans (RPP) or Registered Retirement Savings Plan (RRSP), Child care expenses, Moving expenses, Annual union or professional dues, certain business losses, interest and fees paid for investments, etc.
Tax Credits
“There is no such thing as a good tax.” — Winston Churchill
While tax deductions reduce your taxable income, tax credits on the other hand, directly reduce the amount of taxes due, dollar-for-dollar.
In Canada, tax credits are generally determined by applying a 15% rate to the tax credit amount. In other words, if you have a $1,000 eligible tuition amount, you get a tax credit of $150. There are two types of tax credits:
- Non-refundable tax credits — these credits help you reduce any taxes you owe and may reduce your tax liability to zero. Examples include personal amounts allowed under the Income Tax Act, charitable donations and spouse/common-law partner credit.
- Refundable tax credits — these credits also help reduce what you owe on taxes and may also reduce your tax liability to zero. Unlike the non-refundable tax credits, these credits can result in you actually getting a tax refund if there is any amount left over after reducing your tax to zero. Examples include the goods and services tax/harmonized sales tax (GST/HST) credit and the Working Income Tax Credit.
Which one is better? Tax Credit or Tax Deduction?
It depends.
Tax deductions are generally more valuable if your income is higher since it reduces your tax at your marginal tax rate.
If you’re in the lowest tax bracket, a deduction and a tax credit are essentially the same since the rate used in calculating the tax credit is approximately the same as tax rate in the lowest tax bracket.
Obviously, if you have the option of choosing between a $1,000 tax deduction and a $1,000 tax credit, the tax credit will be superior as this gives you a dollar-for-dollar reduction in your taxes due compared to the tax deduction that will reduce your taxes due at your marginal tax rate.
Why does it matter?
It is important you understand all the available tax deductions and tax credits to determine which one applies to you as taxpayers often miss this.
Bear in mind that the deductions you are eligible for will change throughout your life. For example, a 70-year-old taxpayer will be most interested in the age and pension income deductions while a final year university student may only care about tuition deduction.
Even though some of these deductions change during your lifetime, many of them apply throughout your life or can be transferred to another taxpayer.
In Conclusion
“A fine is a tax for doing something wrong. A tax is a fine for doing something right.” — Anonymous
A good practice to adopt before filing your taxes is to obtain a checklist of all allowable deductions and credits and review each one to determine which one you qualify for based on your situation.
This small exercise can save you taxes. A dollar saved in taxes can certainly help in accelerating the growth of your wealth.
And before you go…
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