How is a tax credit different from a tax deduction?

A tax credit is distinct because it directly reduces the amount of tax owed, rather than being subtracted from income. This means that a tax credit is applied after your taxable income has been calculated and effectively lowers your total tax bill on a dollar-for-dollar basis. For example, if you owe $1,000 in taxes and you have a tax credit of $200, your tax liability is reduced to $800.

In contrast, tax deductions lower the amount of income that is subject to tax. Deductions decrease your taxable income, which then reduces the total tax you owe, but not as directly or efficiently as credits do since they only decrease your liability by a percentage of the deduction amount depending on your tax bracket.

So, in a tax system, a credit is a more powerful tool for reducing liability compared to a deduction because it directly reduces the tax paid, while deductions merely reduce the income that is taxed. The other options do not accurately convey the distinctions between credits and deductions, which is crucial for understanding how each affects your tax situation.