You'll often hear the terms "tax credit" and "tax deduction" used to refer to the various tax breaks to which you might be entitled. However, these terms refer to two different things with different impacts on your taxes.
Which is better: a tax credit or a tax deduction? Which are you more likely to qualify for? Are their limits on how many you can take?
Here is a primer on the differences and some of the rules regarding tax credits and tax deductions.
Deductions can reduce your taxable income
A tax deduction reduces the overall amount of income the IRS considers to be "taxable," but only if you itemize your deductions.
Basically, every taxpayer is entitled to what is called the "standard deduction," which is $6,200 for single taxpayers and $12,400 for married couples filing jointly for the 2014 tax year. You should add up all of the deductions you qualify for, and if the amount is less than the standard deduction, you'll be better off not itemizing.
But itemized deductions are higher for many people, and some common deductions can save you thousands of dollars. For example, if you itemize deductions, you are entitled to deduct any interest you pay on your mortgage.
There are also deductions known as "above-the-line deductions" that you can take even if you choose not to itemize. Student loan interest is one of these, as are qualified moving expenses and some types of retirement savings. Teachers can deduct up to $250 in classroom expenses, even if they don't itemize.
Is there a limit to the deductions you can take?
There is a limit to deductions if your income is high enough. For individual taxpayers with adjusted gross income -- basically your total income minus any of those above-the-line deductions -- of more than $254,200, or married taxpayers filing jointly with AGI above $305,050, there is a limit on the amount of itemized deductions you can claim in 2014.
Only certain types of itemized deductions are affected by the limit, such as interest paid, gifts to charity, and job expenses, as well as various others. Some deductions -- including medical expenses, investment interest expenses, and casualty and theft loss -- are not subject to any limitations.
Credits reduce the amount of tax you owe
A tax credit works a little differently from a deduction in that it reduces the amount of tax you owe, dollar for dollar. For example, if after your deductions the tax tables say you owe $3,000, but you have $500 in tax credits, your tax liability drops to $2,500.
Most tax credits are intended to benefit lower-income individuals, and most phase out above a certain income level. For example, the Child and Dependent Care Credit, which is one of the IRS' most popular credits, can give you up to 35% of the first $3,000 of qualifying child care expenses per child. However, the percentage is incrementally phased out for those who make more than $15,000 per year.
Most tax credits can reduce the amount of your tax owed, but they can do no more. For example, if you are entitled to a $700 child care credit, but your tax for the year is just $500, you won't receive an additional $200; your tax for the year will simply be reduced to zero.
There are, however, what are known as "refundable" credits. For example, the American Opportunity Tax Credit can be worth up to $2,500 toward the cost of qualified higher-education expenses, and up to 40% ($1,000) of the credit is refundable. So if you are entitled to the full $2,500 credit and your tax for the year is just $2,000, you will get the full credit as part of your tax refund. Just like most other credits, this one also begins phasing out above incomes of $80,000 and disappears completely above $90,000
When in doubt, defer to the experts
The laws regarding taxes can be complicated, to say the least. Some deductions and credits require complex worksheets and several pages of instructions to understand.
If you aren't sure whether you qualify for a certain deduction or credit, ask a professional. Some situations are very technical and require an in-depth knowledge. With a basic understanding of how tax deductions and tax credits work, you can better plan your own taxes and potentially save yourself a lot of headaches when tax time rolls back around.
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