What is a tax credit vs tax deduction

what is a tax credit vs tax deduction

Tax deduction vs Tax credit

Judging from some comments, both here and on many other blogs there is some confusion between what constitutes a tax deduction and how a tax credit works. That's understandable I suppose. Many people simply take all their income slips into a tax preparer and have them complete the final income tax return, or they let a piece of computer software do the job. They never see the actual process.

The Harper/Flaherty budget has added an entire menu of tax credits which may or may not affect the outcome of any given income tax return.

A good number of people seem to be assuming that the various tax credits included in Flaherty's budget perform as an income tax deduction. That simply is not the case. In fact, almost all of the tax credits announced in the budget are non-refundable. When Flaherty announced a $1000 employee's tax credit, it doesn't mean a $1000 deduction from a persons taxable income. The only new deduction announced in the budget was the Trades Peoples' Tool Expense.

The following example is a demonstration. (Numbers are bogus except for the tax rate).

Earned income $45,000 on T4 slips

minus RRSP contribution $5,000 (deduction)

equals taxable income $40,000

multiply taxable income by 22%

tax owing before credits $8,800

Keep that $8,800 figure on the page. It is the prime operator from which your final tax figure will be derived. At this point you have not applied tax credits. Keep in mind that even if your tax rate is, for example 22 percent, as it is above, tax credits are calculated at the lowest tax rate. (For what it's worth, that is a disadvantage for middle income earners.)

Now work out your tax credits:

Personal exemption $9,000

multiplied by 15.5%

equals a tax credit of $1,395

Employee tax credit $1,000

multiplied by 15.5%

equals a tax credit of $155

Now add both tax credits together for a total of $1,550

You now take

your income tax owing of $8,800 and subtract $1,550

Many people are under the misconception that a tax credit somehow returns the amount of the announced tax credit to the taxpayer, and as can be seen from above, that simply isn't the case. Further, even if you are taxed in a higher bracket a tax credit, unlike a straight deduction, will only return money at the lowest tax rate. To clear that up a little, from the example above, instead of getting 22% of $1,000 back as a credit you get 15.5% - $155 instead of $220.

Almost all tax credits are non-refundable. If, for example, you had a significantly lower income, thus a less income tax owing, and were able to claim a number of tax credits, if the amount of your credits exceed the amount you owe, you will pay no tax - but you will not get a bigger refund.

A part-time worker earning $10,000 annually is taxed at 15.5%.

Income tax owing is $1,550 .

On a basic personal exemption of $9,000 the credit is $1,395 .

The $1,000 employee tax credit provides a credit of $155 .

You buy 12 monthly bus passes at $80 per month or $960 annually.

Your bus pass credit is (960 x 15.5%) for a credit of $149 .

Your total credits equal $1,699. which exceeds your tax owing by $149. You don't get the $149 in a refund. You simply don't pay any taxes.

If you're curious about who brought in this system, well, he's still around. It was none other than Michael Wilson - creator of the GST and now Canada's ambassador to the USA.

Good or bad, there it is. I hope it clears up some of the confusion.

Disclaimer: The figures above are for demonstration purposes. With the exception of the tax rate, income tax credits and figures may be different. Check with Canada Customs and Revenue Agency for precise calculations. The above examples do not include other standard deductions and credits.

Source: thegallopingbeaver.blogspot.ca

Category: Credit

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