What is the difference between a tax deduction and a tax credit?

A tax deduction and a tax credit serve different functions within the tax system, making the first choice the most accurate. A tax deduction reduces your taxable income, which in turn reduces the amount of income that is subject to taxation. For example, if you have a taxable income of $50,000 and you take a tax deduction of $5,000, your new taxable income becomes $45,000. This indirectly lowers the overall tax liability based on the tax rate applied to that reduced income.

On the other hand, a tax credit directly reduces the amount of tax owed. If you owe $1,000 in taxes and you have a tax credit of $200, your tax bill is effectively lowered to $800. Thus, while deductions decrease taxable income and subsequently affect the overall tax, credits provide a direct reduction in the final amount owed.

The other choices do not accurately represent the key difference. Tax deductions and credits are not interchangeable terms; they have distinct purposes within tax law. Additionally, both deductions and credits can apply to individuals and businesses, and wealth alone does not dictate who can claim deductions.