When it comes to income tax, there are many ways in which the tax due to be paid can be reduced. The basic idea is to reduce the amount of taxable income so that the tax due on said income can also be brought down. But it is not always as simple as that. When it comes to reducing the taxable income, there are two terms that are frequently used. These terms are tax credit and tax deduction. So what do these two terms actually mean? Let’s take a closer look.
What is a Tax Credit?
Tax credits are basically rebates that the government can provide in case of special circumstances surrounding a person. Some tax credits made available in India are:
- If income has been earned outside the country and a tax paid on it in that country then a tax credit can be claimed in India for the tax that has been paid outside.
- Anyone who has an income less than Rs. 5 lakhs per annum but is liable to pay taxes can claim a tax rebate of Rs. 2,000.
- Citizens who are above the age of 65 years can expect to get a tax credit of up to Rs. 20,000,
- Even those with disabilities, falling under a particular income bracket can receive tax credits.
What is a Tax Deduction?
A tax deduction is an investment in an instrument that can directly lower the taxable income of a person. Some examples of these deductions are investments in life or health insurance, mutual funds, tax saving fixed deposits and National Savings Certificates. Each of the instruments that provide these deductions are defined under various sections of the IT Act of 1961. However there is a limit to these deductions of Rs. 1.5 lakhs. This means that a person can make investments to the tune of Rs. 1.5 lakhs to reduce their taxable income. Any income above that mark will be liable for tax under the appropriate slabs.
The sections that decide the tax deductions are:
- Section 80C: This is the section of the IT Act that provides tax benefits on instruments like life insurance, fixed deposits, etc.
- Section 80CCC: This is the section that deals with deductions related to investments in pension plans.
- Section 80D: This is the section that allows investments towards a health insurance plan be submitted for tax deductions.
Difference between Tax Credit and Deduction?
Even though these two facilities serve to reduce the tax that is due there are two main differences between tax credits and deductions. The first and most important one is that a tax credit reduces the actual tax that is owed to the government whereas a tax deduction reduces the income that can be considered for the computation of tax.
The second difference between these two is that a tax credit is applied to the tax owed after tax deductions have been applied. For example, a person who has an annual income of 4.2 lakhs makes certain investments in insurance which grant him tax deduction. After having accounted for these deduction, his tax due is calculated to be about Rs. 8,000. Now since the income is below Rs.5 Lakhs per annum he is eligible for a tax credit of Rs. 2,000. This means that the new tax due is just Rs. 6,000.
This example brings us to yet another difference between these two which is that a tax credit can be applied irrespective of any investments made since it is granted to people by virtue of falling under a specific category eligible for tax credit. However, if no investments are made by the individual in the year, then no tax deductions will be applied to the earnings and the taxable income will not come down.