This year is almost over, and that means that you have some time left to figure out what tax breaks are still available to you. These tax breaks include deductions and credits. It is important to understand, though, that there are differences between deductions and credits. Understanding these differences can help you better plan your taxes. Here is an overview of the difference between deductions and credits:
Tax deductions are items that lower your taxable income. You subtract (deduct) these costs from your income before the tax on it is figured. With enough deductions, your taxable income can be reduced by a fairly decent amount — sometimes even bumping you down a tax bracket. Manny Davis explains that there are four main types of tax deductions:
- Above the line: These are tax deductions taken mostly on the front page of your Form 1040. Above the line deductions lower your income and are part of what results in your adjusted gross income (AGI).
- Schedule C: These are deductions made for businesses who need to fill out the Schedule C. Other schedules that offer deductions are F (for farmers) and E (for rental property).
- Itemized: These are the items that are reported on Schedule A. There are a number of eligible deductions that can be itemized, lowering your taxable income. This is where you report mortgage interest paid and charitable donations, among other costs.
- Standard: The standard tax deduction is fixed amount that can be used to lower your taxable income. Everyone has access to this deduction, which is based on your filing status. You cannot take the standard deduction and itemize; you must choose one or the other. If your itemized deduction is greater than the standard deduction, it’s better to do that. If, however, your qualified expenses don’t add up to more than the standard deduction, it’s better not to itemize.
Tax deductions can be helpful, and they do have value. But they are not quite as valuable as tax credits.
Tax credits, on the other hand, lower your tax liability dollar for dollar. This year, tax credits for energy efficiency and for home buying have been offered. After all of your deductions are accounted for, you end up with a number that represents your taxable income. This is the amount that is looked up in the tax table to see how much you owe. Once you know what you owe in taxes, you can start applying credits.
A tax credit is kind of like a gift card. It counts directly toward what you owe, lowering that amount. If you owe $5,000 in taxes, but are eligible for a $1,800 Hope credit, you would only owe $3,200. Of course, other tax credits, such as the child tax credit and the Earned Income Credit could further decrease your tax liability. If you have enough tax credits, and if you have already paid some of your tax through your employer, the government might actually owe you money and issue a refund.
It is in your best interest to consider what tax credits and tax deductions are available to you. Planning your finances in a way that allows you to lower your taxable income and take advantage of different credits can help you keep more of your money.