With the New Year upon us, it’s a good time to start thinking about tax planning. A key part of this is knowing the difference between tax deductions and tax credits. Understanding these can help you manage your taxes better and boost your household’s wealth.
**Tax Deductions**
Tax deductions reduce your taxable income by subtracting certain amounts from your gross income. There are two main types of deductions. “Above the line” deductions are figured out on the first part of your Form 1040 and they help determine your adjusted gross income. The second set of deductions includes the standard deduction or your Schedule A deductions, found on the second part of Form 1040. These further reduce your income to arrive at your taxable income.
**Tax Credits**
Unlike tax deductions, a tax credit doesn’t lower your taxable income but instead reduces the total tax you owe. After figuring out your taxable income with all deductions applied, you then use tax tables to find out your tax liability. At this point, you apply tax credits to reduce the final amount you need to pay. Think of a tax credit like using a gift card to lower your bill. Sometimes, if your tax credits are more than what you owe, you might get a tax refund.
Tax credits are often seen as more valuable than tax deductions because they reduce your tax bill dollar for dollar, as opposed to just lowering your taxable income.
**Tax Advantages**
To make the most of tax deductions and credits, it’s smart to keep track of eligible expenses throughout the year. Hold onto all receipts and documents to back up your claims if you’re ever audited. As you plan for the year, consider tax credits and deductions so you can gather them gradually instead of rushing at the last minute.
To make sure you’re making the best choices, think about consulting a qualified tax advisor.