Demonstrate the differences resulting from a $1,000 tax credit versus a $1,000 t

Question

Demonstrate the differences resulting from a $1,000 tax credit versus a $1,000 tax deduction for a single taxpayer in the 25% tax bracket with $40,000 of adjusted gross income (AGI). (Please show your work.

For tax deduction, you need to find taxable income first (assuming there is only $1,000 tax deduction and no exemptions or tax credit) before you find the tax liability. For tax credit, you need to find tax liability first (assuming no tax deductions or exemptions so taxable income=$40,000) and subtract tax credit from the tax liability you find.

Explanation / Answer

I am going to do this using 2014 tax brackets, but you will have to appropriately adjust the answer if you are using different brackets.

For 2014, the cutoff for 25% is $36,900 so tax is $5081.25 plus 25% of the amount over $36,900.

For this problem, if we use the deduction, your new AGI is $39,000 so your total tax owed is $5606.25 (25% of $(39,000-36900) + 5081.25).

If we use the credit, your AGI stays at $40,000, your pre-credit tax is $5856.25 (25% of $(40000-36900) + 5081.25), but the $1000 credit reduces your total tax to $4856.25. Credits are always better than deductions.

Keep in mind these are using real world 2014 brackets and that a 25% bracket does not mean all your income is taxed at 25%.

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