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What Is Tax Credit And How Do They Work?

Tax Credits
Tax Credits

A tax credit is simply a cut on tax bills on a dollar-for-dollar basis. With that said, let us take a closer look at what tax credits are and how they work!

Tax Bill [Photo: Shutterstock]

Tax Bill [Photo: Shutterstock]

In layman’s terms, a tax credit can cut dollars off a taxpayer’s tax bill. One of the most known types of tax credits is the Child Tax Credit the government issued monthly to families with children across the country. To further understand what a tax credit is, let us take this as an example. If a taxpayer owes $1,000 in taxes, a $600 worth of tax credits will cut the tax bill to $400. 

According to Ramsey Solutions, tax credits can also be considered money in the bank. The more tax credits one has, the less money they have to pay to the government. Most tax credits are connected with one’s age, income, or status of filing. They intend to provide additional cash to individuals with children, with disabilities, or those with low to average incomes.

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Difference Between Tax Deduction and Tax Credit

According to Ramsey Solutions, tax deductions are somewhat related to tax credits. However, deductions do not directly reduce the tax bills. Instead, tax deductions reduce the taxable income. In turn, if the taxable income lowers, the tax bill also lowers. For example, if a taxpayer is in a 22% tax bracket, a $1,000 tax deduction will lower the taxable income by cutting the tax bill by $220. On the other hand, a taxpayer will save exactly $1,000 for a $1,000 in tax credits.

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