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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 depends, 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 tax 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 $100 tax credit. The government is, in essence, saying to you "We are giving you credit for having already paid $100 in tax." Therefore, $100 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 Tax Credit, and the Child Tax Credit. There are 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 $1,000 in tax. For the purposes of this illustration, you are eligible for either a $1,000 tax deduction or a $1,000 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.