Now that the New Year is underway, it is time to start thinking about taxes. One of the things to consider at tax time is the difference between deductions and credits. This is also an important distinction to consider when you are planning for the coming year. You want to increase your tax efficiency, improving your household wealth, and part of that is knowing the difference between a tax deduction and a tax credit.
This type of tax advantage reduces your taxable income. These are items that are deducted from your gross income to adjust it in order to get your taxable income. There are two main types of deductions. There are above the line deductions, which are figured on the front part of your Form 1040, and are used to figure out your adjusted gross income. The other deductions come on the other side of the Form 1040, and include the standard deduction or your Schedule A deductions. This second round of deductions reduces your income further so that you arrive at your taxable income.
While a tax deduction lowers your taxable income, a tax credit reduces the actual amount of taxes that you pay. After you have taken all of your deductions and arrived at your taxable income, you use provided tax tables to determine how much you owe in taxes. Once you have that number, you can begin applying credits to reduce the amount you owe. A tax credit is a dollar for dollar reduction in what you owe. It’s very similar to taking a gift card and applying it to your balance. If you have enough in tax credits, you can owe negative taxes — which means that the government owes you money and will issue a tax refund.
Tax credits are generally considered more valuable than tax deductions. This is because lowering your taxable income doesn’t represent a dollar for dollar value.
It is a good idea to consider eligible expenses paid throughout the year so that you can maximize your tax deductions and tax credits. Make sure that you save applicable documentation so that you are prepared to defend yourself if you are audited. As you get ready for 2011, it is a good idea to build tax credits and deductions into your financial plan so that you can accumulate them throughout the year, rather than frantically trying to add them up at the end of the year.
You can consult with a knowledgeable tax professional to help you ensure that you are planning appropriately.