Credits, Deductions and the Cigar Box

You probably have met someone with new house that comes with bigger monthly payments than you thought they could afford.  The proud new buyer justifies the spending on the ground that "I needed the deductions."

That statement implies that a $1 tax deduction somehow generates more than $1 of tax savings.  Sadly, life doesn't work that way.  In running your business, its important to understand how much money a tax deduction really keeps in your pocket.

A deduction reduces your taxable income.  A tax rate is applied to that income, and you pay the result.  If you have $1000 taxable income and your tax rate is 25%, you pay $250 in tax.  If you then spend $100 on a deductible amount, your taxable income goes down to $900, and your tax at 25% is now $225.

So before you spent that $100, you had $750 in your cigar box: The $1000, less the $250 tax you had to pay.  After you spent the $100, you had $675 in the cigar box - $900 in income, less $225 in taxes.  Yes, you reduced your tax by $25, but you are $75 poorer for it.

Credits work differently from deductions.  A credit is a direct reduction of your tax, rather than your income.  If you had a $100 credit, instead of a $100 deduction, your $250 tax would become a $150 tax. 

Unfortunately, not many expenditures get you a dollar-for-dollar tax credit.  Credits are typically a percentage of the expenditure.  For example, spending $100 on a new machine under the old investment tax credit would get you a $10 credit, and you could depreciate the remaining $90 cost.

The Moral?  When you are looking at a business expenditure, it's nice that it helps you on your taxes, but the real test is whether you end up with more cash in the cigar box after all your taxes are paid.  Spend money because you need to for your business, not just because it reduces your taxes.