A tax deduction or a tax-deductible expense affects a taxpayer’s income tax. A tax deduction represents an expense incurred by a taxpayer. They are variable amounts that you can subtract, or deduct, from your gross income. It is subtracted from gross income when the taxpayer computes his or her income taxes. As a result, the tax deduction will lower overall taxable income and thus lower the amount of tax paid. The exact amount of tax savings is dependent on the tax rate and can be complicated to determine. For some higher-income taxpayers, claiming all eligible tax deductions would result in having to pay the alternative minimum tax, and would result in a higher amount of tax paid. Tax deductions reduce how much you owe in taxes by decreasing your income. This can put you down into a lower tax bracket, and that means that you will owe less in terms of taxes. There are two types of tax deductions that lower your income.
1. Figuring adjusted gross income. This type of tax deduction comes before you figure out your tax bracket. This is all that stuff that fills in on the front of your Form xxx to get from the number on your earned income down to your adjusted gross income.
2. Deductions from your adjusted gross income. When you flip your Form 1040 over, the first space is for your adjusted gross income. You then begin taking more deductions from there. You either take itemized deductions (Schedule A) or the standard deduction (which depends on your filing status — married, single, etc.). You also get the dependent deduction and other deductions at this point.
3. A tax deduction reduces income subject to tax.
4. For each dollar of tax deduction, the reduction in tax liability is less than a dollar.
A tax credit is a similar concept, but is different in that it reduces the tax owed, rather than reducing taxable income. This amount of tax savings is not dependent on the rate the taxpayer pays. Next is the tax credit. Tax credits are figured after you determine your tax bracket, and how much you should owe in taxes. A tax credit is a dollar for dollar reductions in the amount of tax you owe. You figure out how much tax you owe, and then the credits work as if you are applying a gift card for a certain amount to reduce how much you need to pay.
* A tax credit is a dollar-for-dollar reduction in the tax liability.
* For each dollar of tax credit, there is a dollar reduction in the tax liability.
Deductions vs. Credits
As we all know, deductions and credits are two very important ways to reduce your overall tax liability. Every April, we scramble to find more and more deductions and credits so that we can pay the Tax Man less and less. But which one is best? Which is more advantageous? Which one saves you the most money?
The simple answer is that neither one is best; they are simply two different methods that the IRS gives to reduce the amount of tax you owe. How each impacts you depend, of course, upon your own unique tax situation. You may be eligible to take a certain deduction but not qualify for a particular tax credit. The thing to focus on is awareness of what you can legally claim. This takes knowledge, about your own circumstances as well as what the Tax Code makes available to you. Or, at least, the knowledge of the phone number of a competent tax lawyer or accountant. First, however, we need to get a clear view of what the two terms mean and how they differ.
Let’s start with deductions. A deduction is an expense or an amount of money which lowers your taxable income. It is subtracted “off-the-top” from the amount of money you made throughout the year, your gross income. Once all deductions are subtracted, this amount is known as your adjusted gross income, or AGI. Examples of deductions include contributions to a traditional IRA, student loan interest that was paid during the year, tuition and expenses, alimony paid, and classroom-related costs for teachers. There are also deductions that are related to self-employment income. The standard or itemized deductions are subtracted from the AGI, yielding your taxable income. This is the number which determines the amount of tax that you owe.
Tax credits, on the other hand, are dollar-for-dollar reductions which are subtracted from your tax liability. Let’s say, for instance, that you qualify for a $ xxx tax credit. The government is, in essence, saying to you “We are giving you credit for having already paid $ xxx in tax.” Therefore, $ xxx is subtracted directly from the amount of tax that you owe.
There are tax credits for college expenses, for retirement savings, even for adopting children. Some well-known tax credits include the Hope and Lifetime Learning education credits, the Earned Income Credit, and the Child Tax Credit. There is many more special-interest and business or investment credits as well.
Tax credits can be more valuable than deductions, although somewhat more difficult to qualify for. Let’s assume, for example, that you owe $ xxx in tax. For the purposes of this illustration, you are eligible for either a xxx tax deduction or a $ xxx tax credit. Which would you choose? Well, the deduction, when subtracted from your gross income to get your taxable income, will only decrease the tax you owe by about $ 10. The tax credit would be subtracted directly from the tax you owe, which would mean that you owe no tax at all.
The best strategy when figuring your tax bill is to gather all of the information that you can about which credits and deductions you may be eligible for. Maximize both. And don’t overlook any state-specific deductions and credits where you live. Begin preparing for next year’s tax season now, and you’ll be able to keep more of your money in your own pocket, legally.