As Tax Day draws closer, many are looking for documentation and trying to figure out whether they are taking a deduction or credit for each item that they hope will bring a tax advantage.
Understanding the difference between a tax deduction and a tax credit is important — especially when you stop to consider that one is more valuable than the other.
Is That a Deduction or a Credit?
The difference between a tax deduction and a tax credit can be expressed by the way it affects your taxes.
Deductions are taken before your final income is figured out.
There are different types of tax deductions. The first is an above the line deduction, which takes place before you figure out your adjusted gross income (AGI). You report your total income, and then subtract your deductions, arriving at your AGI.
The second group of deductions are taken from your AGI.
After you have figured out your AGI, you flip over your Form 1040, and begin taking other deductions. You can choose to take the standard deduction, or you can itemize your deductions. Add up what you would itemize (using Schedule A), and see if that number exceeds the standard deduction. You want to choose the larger of your itemized deductions or your standard deduction.
Your second round of deductions are subtracted from your AGI.
The result is your taxable income. In many cases, your taxable income is thousands — or even tens of thousands — less than your actual income. A tax deduction helps you by reducing the amount of money that you have to pay taxes on.
After you have figured out your taxable income, you use that number to see how much you owe in taxes.
Your income can be found on the tax table, and that will provide you with how much you owe. Once you know how much money you owe, you subtract the amount of money you have already paid in taxes, including money withheld from your paycheck and money paid in quarterly taxes.
Now it’s time to add in your tax credits.
The great thing about a tax credit is that it directly reduces what you owe.
This is a dollar for dollar reduction. If you owe $1,000, and you have $500 in tax credits, you only owe $500 total. Having a tax credits is like having a gift card meant to help you pay your taxes.
So, Which is More Valuable?
As you might imagine, having a tax credit is more valuable.
A tax deduction is helpful, since it lowers your taxable income, but it isn’t quite the same. Your deduction might not be enough to knock you down a tax bracket, and it simply reduces the amount of money your taxes are figured on.
A $100 tax deduction isn’t worth $100, since it might only lower your taxable income from $55,000 to $54,900. That makes a difference of $15 when you go to pay your taxes if you are married filing jointly. (According to the IRS tax table, you would owe $7,416 and $7,401, respectively.)
A credit, though, translates directly into dollars saved.
If you have a $100 tax credit, you have a $100 tax credit. It means that if you owe $7,401, and you apply the credit, now you owe $7,301.
Of course, if you have already paid your taxes, you could end up with a tax refund. The Earned Income Credit and some other credits can result in the government owing you money after all is said and done.