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What is the Difference Between a Tax Deduction and a Tax Credit?

Learn the difference between tax deductions and tax credits and how they can help small business owners minimize tax liability.

Woman business owner working on bookkeeping | Tax Credits & Tax Deductions

Published on

Jan 10, 2024

Written by

Penelope Team

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As a small business owner, navigating the world of taxes might be the last thing you want to do. But, understanding the difference between tax deductions and tax credits is important for optimizing your tax strategy and minimizing your tax liability. 

In this guide, we'll break down the concepts of tax deductions and tax credits, explore their differences, provide examples relevant to small businesses, and how setting up a 401(k) retirement plan for your business can help you save on your tax bill!

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Definition of Tax Deduction

A tax deduction is an expense that the Internal Revenue Service (IRS) allows you to subtract from your taxable income. By reducing your taxable income, tax deductions can lower the amount of income tax you owe. Common tax deductions for small businesses can include:

  • Office Expenses: This includes rent, utilities, and other expenses related to the physical office location.
  • Business Travel: If you travel for business purposes, many of these expenses can be deducted including airfare, hotel costs, and meals.
  • Depreciation: If you purchase property for your business, you can deduct a portion of the cost each year over its useful life.
  • Employee Salaries: The wages you pay to your employees are fully deductible, as long as they are reasonable and directly related to your business.
  • Supplies and Equipment: The cost of office supplies or equipment used in the course of business operations can also be deducted.
  • Advertising and Marketing: Costs related to promoting your business, such as advertising, marketing, or website fees, are deductible expenses.
  • Retirement 401(k) Plans: Employer contributions are tax-deductible, and the money in the plan grows tax-free until it is withdrawn by employees in their retirement years. Find the right Penelope Retirement plan for your business →

However, tax deductions can change from year to year. This is because they are determined by tax laws, which can be modified or updated based on new legislation passed by Congress and signed into law by the President. These changes may include adjustments for inflation, the introduction of new deductions, or the elimination or modification of existing ones. We always recommend consulting with a tax professional or checking with the IRS or your state's tax agency to help you understand the current tax deductions available.

Definition of Tax Credit

A tax credit is a dollar-for-dollar reduction in the actual tax amount owed. Unlike deductions, which reduce your taxable income, tax credits directly reduce the amount of tax you owe to the IRS. This makes tax credits especially valuable as they provide a more significant reduction in tax liability.

Similar to tax deductions, tax credits can change yearly. For example, in response to the COVID-19 pandemic, several new tax credits were introduced and existing ones were expanded to provide financial relief to individuals and businesses. Always consult a tax professional or the IRS website for the most current information.

Differences Between Tax Deduction and Tax Credit

The main difference between tax deductions and tax credits is they affect your tax liability. Tax deductions reduce your taxable income, while tax credits reduce the actual amount of tax owed. In simple terms, deductions lower the portion of your income that is subject to tax, while credits directly reduce the tax bill.

Tax Deductions and Credits for Small Businesses Offering Retirement Plans

For small business owners, offering a retirement plan for their employees may seem too expensive or too time-consuming to manage, but that isn't the case — especially with Penelope. Explore these tax credits and tax deductions that are available for small businesses offering retirement plans:

Tax Deduction: Offering a 401(k) retirement plan to employees can qualify for tax deductions. Employer contributions made to employees' retirement accounts are tax-deductible up to 25% of the total contribution as long as it doesn't exceed the limits outlined in section 404 of the IRS code.

Tax Credit: The Secure 2.0 Act introduced a tax credit for small businesses that offer a 401(k) plan to employees. This credit provides an additional incentive for business owners to provide retirement benefits to their workforce. Qualifying businesses can receive up to $16,500 in tax credits spread over three years.

Keep reading: Tax Credits for Small Business Retirement Plans →

These examples illustrate the potential tax advantages of offering a 401(k) plan, both in terms of deductions and credits. For the most accurate and up-to-date information, you should consult the IRS website or a tax professional.

How to Claim Tax Deductions and Credits

To claim tax deductions and credits, it's essential to keep accurate records of your expenses and consult with a qualified CPA or tax advisor. They can guide you through the process, ensure compliance with tax laws, and help you maximize your tax savings. Each deduction and credit may have specific requirements and limitations, so professional advice is invaluable.

Tips for Staying Organized to Maximize Your Tax Deductions and Credits:

  • Stay Organized: Keep a dedicated space for all your business-related receipts and invoices. Consider using a filing system with categories for different types of expenses.
  • Use Accounting Software: There are many software options available that can help you track income and expenses, generate reports, and even prepare for tax filings.
  • Keep Business and Personal Expenses Separate: Always use separate bank accounts and credit cards for business and personal transactions. This will make it easier to track your business expenses.
  • Regularly Update Your Records: Rather than waiting until the end of the year, update your records regularly. This could be daily, weekly, or monthly, depending on the volume of transactions.
  • Retain Records for the Appropriate Amount of Time: The IRS generally recommends keeping records for three years from the date you filed your original return, or seven years from the date you paid the tax, whichever is later.
  • Understand What Can Be Deducted: Not all business expenses are tax-deductible. Make sure you understand which expenses qualify for deductions and tax credits.
  • Hire a Professional: Consider hiring an accountant or tax professional. They can provide advice tailored to your specific situation, ensure you're maximizing your deductions and credits, and help you avoid potential pitfalls.

Set Up a 401(k) Retirement Plan and Discover Your Tax Savings

Understanding the difference between tax deductions and tax credits is key to optimizing your tax strategy as a small business owner. While deductions reduce taxable income and credits directly reduce the tax owed, both can significantly impact your overall tax liability. By leveraging deductions and credits relevant to your business, such as those associated with offering a 401(k) plan, you can take advantage of tax benefits and promote financial wellness for both your business and employees.

Don't forget to consult with a tax professional to ensure you're capitalizing on all available deductions and credits. Discover the tax credits you can receive for offering a 401(k) retirement plan to your employees and take a step toward enhancing both your business and employee benefits. Tell our retirement specialist about your business to see what Penelope Retirement plan is a fit for your business.

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