Everyone loves to save money on their taxes, but do you know which items will save you the most at tax time? Should you rack up tax deductions or focus on getting as many tax credits as possible? There is a big difference between a tax deduction and a tax credit; that difference can be the key between a big tax refund and owing the federal government thousands of dollars.
Generating discounts on your taxes also impact your retirement account selection. If you have a misunderstanding of what sort of tax discount you are getting, you might make a less than ideal choice.
What is a Tax Deduction?
A tax deduction is an item the government lets you write off of your taxes to lower your taxable income. Deductions usually only apply if you itemize your deductions rather than taking the standard deduction. The first key concept with tax deductions is how taking a deduction lowers your taxes. You don’t get a dollar off of taxes for every dollar spent. Instead, every dollar that is deducted from your taxable income lowers the amount of income you will be taxed on. If you are in the 25% tax bracket, for every dollar you deduct you get a 25 cent tax break.
The second key concept is that a tax deduction may not be of any use to you. If you don’t rack enough deductions to overcome the standard deduction ($11,600 for married couples, $5,800 for singles, and $8,500 for head of household filers) then you don’t get a discount on your taxes at all. If you justified spending $2,000 on something just to get the tax deduction but have no other deductions, you have wasted your money and you get no discount for the $2,000 you spent.
What is a Tax Credit?
A tax credit is a direct reduction of the amount of tax you owe. A credit can be issued for spending money on green home improvements or for going back to school with the lifetime learning tax credit. No matter which credits you use, you are getting a direct reduction of your tax owed to the federal government. Even if you take the standard deduction and have $2,000 in tax credits, you get a direct reduction of your taxes by $2,000 while enjoying the high standard deduction. A tax credit will always reduce your tax due.
Are Deductions of Credits Better?
A tax credit is much better than a tax deduction. Not only will a tax credit always reduce your taxes (while a tax deduction might, if you have enough deductions), a tax deduction is not a direct reduction of your tax owed. If you had the opportunity to take a $5,000 tax credit or a $5,000 tax deduction, the credit is the better deal.
If you originally owed $10,000 in taxes, the tax credit would directly lower your taxes due to $5,000. The tax deduction would lower your taxable income by $5,000, not your tax due. If you were in the 25% tax bracket, your taxes would be reduced by $1,250 to $8,750.
Utilize Both and Maximize Your Refund
The beautiful thing about both of the tax discounts if you don’t have to choose one or the other. You can rack up as many tax credits and tax deductions as you like as long as you qualify for them. Tax credits are usually more elusive and not as easy to claim than tax deductions, but if you apply they are a great boost to the size of your refund. Tax deductions can be valuable in lowering your taxable income, but only if you have enough deductions to overcome the standard deduction.
This article is by Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.
Photo by Quinn Dombrowski via Flickr