The tax code is complicated, and even the moves that the recent tax reform efforts made to simplify some tax calculations didn't go as far as they could have to eliminate the complex system of tax breaks that taxpayers have to navigate in order to pay as little tax as possible. Not only do you have to know that various tax breaks exist, but you also have to be able to compare the impact each one will have on your tax bill and make smart decisions about which ones can help you the most.
One confusing thing that often comes up with tax breaks involves the different categories of benefits that you'll find. Some tax breaks are structured as credits, while others provide deductions or exemptions from tax. Below, we'll take a closer look at each of these types to give you a sense of how you can best compare them in your tax planning.
What's the difference between a credit and a deduction?
The most common tax benefits that you'll run into are credits and deductions. A tax credit allows you to reduce any existing tax liability by $1 for every $1 of credit you earn. Therefore, if you qualify for a $1,000 tax credit, then it will cut your tax bill by $1,000 as long as you already had at least $1,000 of tax liability.
Deductions are different. Rather than reducing your tax liability directly, deductions reduce your taxable income on a dollar-for-dollar basis. When you run that lower taxable income number through the tax calculation formula, that results in your owing a smaller amount of tax, but the amount of the reduction depends on the tax bracket that you're in.
Which tax break is worth the most?
Overall, it'll always be the case that a credit of a certain amount will be worth more in tax savings than a deduction of the same amount. The problem is that it's rare for a credit to be in the exact same dollar amount as a corresponding deduction. When the two amounts aren't the same, a lot depends on the particular tax rate that you pay.
For example, say that you have $4,000 in educational expenses for which you'd like to claim a tax break. You've determined that you have a choice between taking the tuition and fees deduction or the lifetime learning credit, but the tax laws won't let you claim both in the same year for the same student. Therefore, you have to pick. The credit provides you a tax break of 20% of the amount you pay, so you'd earn an $800 tax credit using the lifetime learning credit that you could use to reduce your other tax liability. The tuition and fees deduction lets you cut your taxable income by the full $4,000 that you paid.
The tax savings from the credit is easy to calculate: It's the $800 amount, based on the assumption that you have at least that much tax liability to offset elsewhere. But the deduction can be worth different amounts. If you're in the 10% bracket, then a $4,000 deduction would save you $400 in tax. You would therefore take the $800 credit, because it produces greater tax savings. If you're in the 24% bracket, though, then the deduction would reduce your taxes by $960. That's a better deal than the credit, so you'd go with the deduction instead.
What about exemptions?
The good news is that exemptions act exactly like deductions in that they lead to your having less taxable income than you'd otherwise have. For instance, when you contribute money to a traditional 401(k) plan, that income becomes exempt from current tax. IRA contributions are instead characterized as deductions. The net result is the same: less taxable income that produces a smaller tax bill.
Your best bet
The last thing to keep in mind is that many times, credits or deductions are only valuable if you owe tax. If you zero out your tax liability, then a tax break might not do you any good. Exceptions are tax breaks that are treated as refundable credits, because they're designed to pay you a refund even if you don't have any tax left to pay.
Ideally, it's smart to take every tax break you possibly can. When you have to choose, there's no substitute to running the numbers and seeing which ones leaves you further ahead. That way, you'll always make the move that gives you the lowest tax bill you can possibly have.
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