Now that tax season is in full swing, countless Americans will surely be rushing to complete their returns by the upcoming April 17 deadline. If you're deep in tax mode, you may be confused about the various benefits you're entitled to -- namely, credits and deductions. Furthermore, you may be wondering which of the two tend to be the most lucrative.
Here's the quick answer: When you're dealing with a tax credit and a tax deduction that are equal in amount, the credit will always offer more tax savings than the deduction. Otherwise, it can very well be the case that a deduction is worth more to you than a credit, or vice versa.
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Tax credits versus deductions
To determine the value of tax credits and deductions, you need to understand how each benefit works. A tax deduction allows you to exempt a portion of your income from taxes, and its ultimate value will be a function of your effective tax rate. Say you're entitled to a $1,000 deduction, and your effective tax rate is 25%. That will result in $250 of tax savings. But if your neighbor takes a $1,000 deduction and his effective tax rate is 30%, it'll be worth $300 to him.
In fact, it's for this reason that lawmakers have long criticized tax deductions as unfairly favoring the rich. The logic in that argument is that wealthier Americans with higher tax rates will always get more savings out of deductions than those who pay less tax, percentage-wise, on their income. But so goes the system.
Now let's talk about tax credits. A tax credit is a dollar-for-dollar reduction of your tax liability whose value isn't impacted by your effective tax rate. A $1,000 credit, for example, is worth $1,000 whether your effective tax rate is 25%, 30%, or something else.
That said, higher earners -- those who tend to have the highest effective tax rates -- are often unable to capitalize on tax credits because most phase out at higher income levels. The Earned Income Tax Credit, for example, is only available to single tax filers earning $49,194 or less and joint filers earning $54,884 or less.
Should you go after tax credits or deductions?
If you're wondering whether it pays to go after tax credits versus the deductions, the answer is: Aim to snag both. The two need not be mutually exclusive, and each individual tax break you get can serve the key purpose of lowering your IRS bill.
Imagine you're eligible for the full American Opportunity Tax Credit, which is worth up to $2,500. That's an automatic $2,500 reduction in your tax liability. But if you're eligible for a number of deductions as well, by all means, take them.
As far as relative value goes, it really depends on the numbers you're working with. If you paid a total of $12,000 in mortgage interest last year, and your effective tax rate is 25%, you'll save $3,000 on your 2017 taxes. If you also happen to be eligible for the full American Opportunity Tax Credit, that's another $2,500 in savings you'll get. In this instance, your deduction is worth more than your credit, but that's only because the former was so high to begin with. But had you paid $2,500 in mortgage interest, that would've translated to $625 in tax savings.
The point here is that there's rarely any sense in comparing the value of tax credits and deductions, because with a few exceptions, you're not required to choose between them. Take as many of each as you're eligible for, and with any luck, you'll get some nice savings on your return.
