It's smart to manage your taxes so that you only pay your fair share, and two ways to
manage your tax burden are through tax deductions and tax credits. But those can be confusing. So,
what is the difference, and which one's better, and how do they work?The short answer is that a
tax credit is generally more powerful than a tax deduction, but tax credits can be hard to come by,
so understanding both of these strategies could be really helpful for you. So, what is a tax credit?
That's a dollar for dollar reduction in the amount of tax you owe, so if you were going to owe one
thousand dollars on your taxes and you got a one thousand dollar tax credit, then that would wipe
it out, and you would owe zero to the IRS for that year. In fact, some credits are even refundable.
So you would get money back if the credit is more than what you owe in taxes. For example, let's
take the Child Tax Credit. Maybe you're going to get a $3,000 tax credit but you only owe $1,000
in taxes. Well, you would get that extra two thousand dollars back as a tax refund. But if
your tax credit is not refundable then you would not be able to get that money back as a refund.
For example if we take the Savers Tax Credit, this one benefits you when you make contributions to
a retirement account, for example, you can get up to half of the amount you contributed as a credit.
But you lose the ability to get that credit if your income goes over certain limits. So that's
tax credits. Now what about deductions? A tax deduction is an entry that reduces the amount of
income that you're going to pay taxes on. In other words you effectively report a lower income for
the tax calculation. Because of that, you actually need income to use a deduction and most people do
have income because they work for a living, and even if you're retired you might have income
from pre-tax account withdrawals or pensions or something else that puts income on your return.
When you have a lower income you have a smaller tax bill, and that's a good thing. Now time for a
quick friendly reminder that this is just a short video. It can't possibly cover everything, so
please do a lot more research before you make any decisions. Most people use the standard deduction
these days, and that's a flat number that's the same for everybody, and of course it's different
for different tax filing statuses, but it doesn't have anything to do with your actual expenses.
It's a decent way to keep things simple and get a nice size deduction because for a lot of people,
their other deductions are not going to exceed the standard deduction, so the standard deduction is
the biggest option available to them and the one that benefits them the most. That said,
if you do a lot of spending in certain categories or have certain things happen to you,
you might have your own deductions, you could itemize deductions and that might add up to
more than the standard deduction. For example, you might have really high medical expenses due
to a health care event and maybe some qualifying interest on your home mortgage, and when you add
all of that together it ends up being more than the standard deduction. Either way, whether you
go with the standard deduction or you itemize deductions, you can reduce the amount of income
you're going to pay taxes on. There are also some things that function like a deduction but they
aren't really deductions so if you contribute to a pre-tax 401k plan at your job for example,
they're going to reduce the amount of income that gets reported on your w-2 by the amount
you contribute to the plan, and that effectively lowers your income that you're going to pay taxes
on, but it's not part of your itemized deductions or your standard deductions so which is better a
tax credit or a tax deduction and it ultimately comes down to everything else on your return so
tax credits again can be more powerful. In other words, a thousand dollar tax credit is better than
a thousand dollar tax deduction. Here's an example of that. We know that a one thousand dollar tax
credit is going to reduce the taxes you owe by one thousand dollars, assuming you owe that much
or if it's at least refundable. Let's assume that you're in a twenty percent tax rate so we
say point two zero times one thousand dollars of a deduction you're going to get. That might
reduce the amount you pay in taxes by two hundred dollars. So again the tax credit would have saved
you a thousand versus a one thousand dollar tax deduction at a twenty percent rate saves you two
hundred dollars. What might be interesting to know is that that one thousand dollar tax credit is
actually the equivalent of a five thousand dollar deduction, and we can double check that by saying
five thousand dollars times twenty percent would result in you paying one thousand dollars less
in taxes. One other way to look at that is to check out your tax form so the deductions are
going to go here on the first page and that goes before we get to your taxable income,
so the deductions again can reduce the amount of income that you're ultimately going to pay
taxes on, and you can take that standard deduction or you can go with something else, but your tax
gets calculated, and then later is when we would come in with the tax credits that actually reduce,
again, dollar for dollar the amount of tax that you're going to end up paying, and that's
on the second page of your 1040. You might not actually use a paper form to file your taxes
anymore but this can help you visualize the order of events. Remember that there are some other ways
to manage your taxes as well, not just tax credits and tax deductions, so for example you could do
tax efficient investing, so that might be sort of a more passive approach where you're not
going to have as much turnover, not going to take short-term gains as often, you might even invest
in municipal securities if that's going to help you, but that's something you really need to look
closely at, and you can also do some tax planning like maybe doing Roth conversions in certain years
when you have a low income so that you can fill up certain tax brackets as you move through life. So,
I hope you found that helpful. If you did, please leave a quick thumbs up, thank you, and take care