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## Finance and capital markets

### Course: Finance and capital markets>Unit 4

Lesson 1: Personal taxes

# Tax deductions introduction

Understanding what a tax deduction is. Created by Sal Khan.

## Want to join the conversation?

• I didn't understand what is the difference between tax deduction and tax credit.
• Andrew is right. Another way to see it is this:
For example....
a) You have calculated your taxes and you owe \$8,000. But wait a minute! You uave a \$1,000 tax CREDIT and you apply it to your FINAL bill is= \$8,000 minus \$1,000 equals \$7,000 check to the IRS. You are very happy.
b) You are calculating your taxes. Your taxable income (salary for example) is \$20,000. Your tax bracket is say 20%. During the year you spent \$6,000 that the government allows you to DEDUCT. So after you report your salary, you take out the amonts you can deduct from your income: \$20,000 minus \$6,000 =\$14,000. The deduction has helped you decrease the income on which the IRS is going to calculate your taxes. See the difference?
Now you pay only pay taxes on the \$14,000 or 20% times \$\$14,000 equals \$2,800 check to the IRS.
The difference is that a tax credit is applied to reduce the final bill...... and a tax deduction is applied against your income to decrease it before you calculate your final bill.
• Could a tax deduction change your bracket? Say, x amount into a bracket, and your tax deduction was x+y. Would that bring you down into a lower bracket?
• If I have more tax deductions than income, will the government give me money? Is that even a possible scenario?
• No, deductions have to be deducted from income. No income, no deduction. However, there are in addition to deductions such a thing as tax credits. A small number of tax credits, including the Earned Income Tax Credit, are "refundable", meaning the government will give you money if your net tax liability is negative.
• Im only in 9th grade, why do we have to learn this so early?
• Taxes is something you should learn as soon as possible, because it's how much less money you will get, also, learning it well will help you from paying an accountant to do your taxes.
• Can you explain in more detail again what Tax Deductions are ?
• An Example: You earn \$100,000 per year. And maybe you can now deduct \$10,000. That means that you only have to pay tax on \$100,000 - \$10,000 = \$90,000.
In general:
Income= I
Tax deduction= d
Tax rate= r
(I - d) * r
• What is the difference between tax deductions and tax credit?
• A tax credit is deducted directly from your tax bill. A tax deduction reduces the amount of your income subject to tax. So if your tax rate is 25%, a \$1000 deduction saves you \$250, but a credit saves you \$1000.
• What sorts of things would cause you to receive tax CREDITS? They sound rather awesome.
• Tax credits are a useful tool to reduce your tax liability. For an individual taxpayer, the most common credits are the Earned Income Credit, the Child Tax Credit and the education credits.

An important point to remember when researching tax credits is that they come in two varieties, refundable and non-refundable. A nonrefundable tax credit (ie. the Child Tax Credit) acts similar to a coupon for your tax liability. It reduces your tax liability but not below zero. For example, if your tax liability is \$300 and you have a \$1,000 child tax credit, your tax liability is lowered to \$0. The remaining \$700 is not used.

A refundable credit increases your withholding. An example of this would be the Earned Income Credit. To continue from my previous example, let's say you have a \$300 tax liability, a \$1,000 Child Tax Credit, and \$5,000 Earned Income Credit. The \$1,000 Child Tax Credit will reduce your tax liability to \$0, but the remaining \$700 cannot be used. Even though your tax liability is zero, the Earned Income Credit will increase your refund by \$5,000.

If you should have any other questions on tax credits, I encourage you to reach out to an Enrolled Agent in the area. They are licensed by the IRS and regarded as the leading tax professionals in the country.
• Just to be clear it is as if you are subtracting the interest twice? Because in order to come up with your gross income you would have taken away what you paid in interest already. So what Sal is saying here is now you subtract it again?