Monday, November 2, 2009

Tax Credits or Tax Deductions

A deduction is an expense or an amount of money which lowers your taxable income. It is subtracted "off-the-top" from the amount of money you made throughout the year otherwise known as your gross income. Once all deductions are subtracted from your gross income, you arrive at an amount known as your adjusted gross income, or AGI. Examples of deductions used to obtain your AGI include contributions to a traditional IRA, student loan interest that was paid during the year, tuition and expenses, alimony paid, and classroom-related costs for teachers. After you obtain your AGI, the standard or itemized deductions are subtracted from the AGI, yielding your taxable income. Taxable income determines the amount of tax that you owe.

Tax credits, on the other hand, are dollar-for-dollar reductions which are subtracted from your tax liability. Let’s say, for instance, that you qualify for a $100 tax credit. The government is, in essence, saying to you “We are giving you credit for having already paid $100 in tax." Therefore, $100 is subtracted directly from the amount of tax that you owe.

The following example illustrates the difference between the two. As earlier stated, a deduction shaves money off your taxable income, so the value depends on your tax bracket. If you're in the 25% bracket, a $1,000 deduction lowers your tax bill by $250. But a $1,000 credit lowers the bill by the full $1,000, no matter in which bracket you are.

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