Most of you file a tax return every year. If you file the 1040, you no doubt have come to know the terms "tax deduction" and "tax credit". There is a distinction, of course, between the two. One of these "tax benefits" is much more beneficial than the other, and sometimes you can get a greater benefit from both, if you know what you are doing.
The tax deduction comes in a two flavors, chocolate and butter pecan (are you awake now?) Seriously folks, the deduction can be the "standard deduction" or you may take take "itemized deductions". The standard deduction is a set amount, and is most commonly used by folks that don't own a home or give significant amounts to charity. The itemized deduction option is commonly used by taxpayers that deduct their mortgage interest payments and money given to charity, as well as property tax payments and miscellaneous deductions, to name a few.
Whichever you choose, the deduction simply lowers the amount of your income subject to taxation. If you earn $50,000 and have $20,000 in itemized deductions, you end up with $30,000 of taxable income (yes, we are already taking exemptions into account!) Let's pretend you are in the 10% tax bracket (a man can fantasize, right?). If you have $20,000 worth of deductions, you end up with $2,000 less in taxes (10% of $20,000 is $2,000).
A tax credit is an entirely different animal. You see, the credit directly lowers your tax owed by a certain dollar amount. For instance, a credit of $1,500 will lower your tax bill by, you guessed it, $1,500. So using our earlier example, let's pretend that the remaining $30,000 of income will be taxed at 10%. The bill is $3,000 right? Well, that bill will be lowered dollar for dollar by any tax credit that the taxpayer is eligible for. So the $3,000 tax bill gets lowered by the $1,500 credit (we'll say it is the Hope Credit for college). By the way, tax credits are calculated based upon money spent for certain expenses such as college, energy efficient items for the home, and more. In tax terms, a credit gives you more bang for your buck.
So now you might be thinking, "I need an Advil, my head hurts!!" It's OK, this kind of thinking hurts everyone to some degree or another. The trick is, a dedicated tax professional knows how to utilize the tax code to maximize credits in relation to certain deductions. You see, some deductions can be taken "above the line," which may affect how a credit is calculated, in deference to taking a deduction "below the line." How about that Advil? Would you like two now?
In closing, the government's scheme is quite complex, and the ability to figure out the best way to comply with that scheme is often less straightforward than what a canned software package would suggest. Credits and deductions are but two benefits in the code. Though quite different from one another, they can be used to minimize your tax bill, and that's a welcome notion these days.
