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Tax Deductions and Credits

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As you begin working on your tax return preparation, it's critical you understand the difference between tax deductions and tax credits. While both are able to help lower your overall tax liability, they do so in very different ways. Once you understand the difference between these key tax terms, you can use your knowledge to your advantage during the entire year, not just tax season.

Tax Deductions

A tax deduction is an expense the IRS allows you to subtract from your income. Subtracting the “above the line” deductions from your gross income gives you your Adjusted Gross Income (AGI). These tax deductions include the items you may deduct whether you itemize deductions for your tax return or use the standard personal deduction provided by the IRS. These tax deductions include:

  • Alimony paid
  • Moving expenses
  • Self-employment tax deduction
  • Student loan interest
  • Tuition and fees deduction.

The other class of tax deductions are those you can claim only if you itemize for your tax return. These include:

  • Business use of home
  • Charitable contributions
  • Home mortgage interest deduction
  • Medical expenses
  • Theft losses.

Tax Credits

Tax credits differ from tax deductions in that you subtract them from the total tax you owe the government, not your income. To some people, this makes tax credits more valuable than deductions because they represent a hard dollar savings. Types of credit you might claim on your tax return include:

  • Child tax credit
  • Earned income credit
  • Education credits.

In addition the standard credits and the tax stimulus credits the government sometimes passes, you get credit for any money you've already paid toward your tax liability. If you work for someone else, this includes the taxes your employer takes from your paycheck every pay period. For self-employed individuals, this would be the estimated tax payments you send to the IRS each quarter.

Considerations for Tax Deductions and Credits

The question of which is more value depends on your personal perspective of taxes. For example, if you owe the government $2,000 and you qualify for a $1,000 tax credit, you just cut your tax bill in half. On the other hand, when you're able to accumulate enough qualified tax deductions, your taxable income may drop enough to lower your tax bracket. It's true that $10,000 in deductions won't cut as much from your tax bill as a $10,000 credit, but if that same $10,000 is enough to knock you into a lower tax bracket, you could save hundreds, if not thousands of dollars on your tax bill.

Both tax deductions and tax credits have their advantages, so it's in your best interest to learn which apply to your financial situation when you prepare your tax return. If you're unsure about which tax deductions and tax credits you can claim, a tax professional can assist you.

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