When filing your personal income tax return, there are primarily two ways to reduce your tax liability: deductions and credits. Although any way to pay Uncle Sam less is greatly appreciated, there are advantages to utilizing different techniques in reducing the amount you pay in taxes. Deductions and credits are actually considerably different creatures and understanding that difference may save you tax dollars.
This is a fairly complex topic, and therefore it will be explained and then an example will be given to illustrate the point.
The fundamental difference in deductions and credits is as follows: deductions are used to reduce your taxable income; however, credits are actually used to reduce the tax itself. The difference may not be apparent immediately, but it will become clearer.
If you look at form 1040, the form you use to file your personal taxes, you will notice first you calculate your income, then you subtract many items and deductions to come to your adjusted gross income; then you continue to subtract more deductions. After this is done, you have your taxable income. Your taxable income is what is looked at in determining your tax liability. However, even after you calculate your tax liability, instead of having to pay that amount, you subtract all of the applicable credits. The result is the amount you actually pay or are refunded, depending on the circumstances. Because deductions are used to calculate your taxable income, you actually only benefit from a portion of the amount of the deduction.
A very simplified example
If you earn $50,000 a year (which is in the 15% tax bracket if married filing jointly) and have $5,000 in deductions, your taxable income is $45,000. You would then pay 15% of that amount in taxes, which is $6,750.
However, earning $50,000 a year in the 15% tax bracket with $5,000 in credits, the amount you would pay in taxes would be $2,500. The reason for this is that your taxable income ($50,000) is multiplied by your tax percentage (15%), THEN you subtract your credits. Because you subtracted your credits AFTER calculating your taxes, you reap the benefit of the full $5,000.
The tax on $50,000 with no deductions or credits, in the 15% tax bracket, would be $7,500. Because the deduction is taken before the tax is computed, you only reduce the tax liability by 15% of your deduction ($750). However, when you are able to subtract the $5,000 credit after calculating your tax liability, you pay considerably less in taxes.
Why does this matter?
It is important to understand the difference between deductions and credits so you can look objectively at certain tax issues. For example, when it comes to educational expenses, you have the choice of claiming the Hope Credit, the Lifetime Learning Credit, or the tuition and fees deduction, assuming you qualify for each option. If you do not fully understand the difference between each option and the tax consequences, you may choose a less desirable option and, therefore, lose money.