With tax season in full swing, it is little surprise that many are wondering about the ins and outs of the whole tax return thing. You may have your tax prep checklist, but one of the main issues that trips many people up is whether something is a deduction or a credit. And what's the difference, anyway? Understanding the difference between a tax deduction and a tax credit can help you plan for better tax efficiency in the coming year, and help your personal finances in the long run.
Tax Deduction
A tax deduction is something that lowers your taxable income. In some cases, healthcare costs, moving expenses, education expenses, charity donations and mortgage interest (and more) are all things that you deduct from your income. Most people generally take these in two places. The first is on the front of the Form 1040. You fill in deductions for certain items, and it lowers your gross income. For instance, if you put in all of your income - and you have made $50,000 in a year - that is your gross income. Then, you take your first round of deductions as seen on the front of your Form 1040. Let's say your deductions add up to $4,000. That means that your new income being considered as taxable is $46,000. This is your adjusted gross income (AGI).
Now that you have your AGI, it's time to take more deductions to figure out your taxable income. You flip your Form 1040 over and on the back you see that there are some serious deductions to be had. You can either take the standard deduction ($11,400 if you are married filing jointly) or fill out a Schedule A to itemize. If your itemized deductions add up to more than $11,400, then you should do those and skip the standard deduction. Let's say that your itemized deductions add up to $15,000. So, you take your $46,000 and subtract $15,000, and your taxable income is $31,000.
You can see how this might help. In both cases, you are in the 15% tax bracket. However, 15% of $50,000 is $7,500, while 15% of $31,000 is only $4,650. Those deductions saved you $2,850 in taxes. But we're not done. It's time for the credits.
Tax Credit
A tax credit is like a gift card that you apply to the amount you owe in taxes. It's a dollar for dollar reduction in the amount of money you owe. In our example, you owe $4,650 in taxes. Then you start applying credits. Let's say you qualify for an earned income credit and an additional child tax credit. Perhaps you have some other credits that you are eligible to claim. With everything, your credits add up to $4,000. That money is applied to the total - just as if you had a gift card. Now your tax liability is only $650. If you have had taxes withheld at work, that amount (which you've already paid in taxes) is applied. If you have $200 a month taken out for taxes, that's $2,400 for the year. You've already paid that, so that money is applied to the $650 that you owe. As a result, you find out that you have a tax refund of $1,750 coming your way.
As you can see, a tax credit is considered more valuable than a deduction. While a deduction lowers the amount of income available for taxation, a credit is a direct reduction in how much you owe. However, combined efficiently, you will find that you can save thousands in taxes.
-- Miranda
Image source: U.S. Navy