When it comes to saving money on taxes, you have a handful of options. For most investors, the easiest paths lie in investing in a 401k plan or other tax deferred retirement plan, and investing in a tax efficient manner so that you aren’t paying unnecessary tax on capital gains, dividends and interest. Yet there are still other ways to save on taxes, namely with tax credits.
Most taxpayers get confused when the topic of tax credits and tax deductions come up. In fact, many mistakenly assume that a tax credit is the same as a tax deduction. The reality is that the two are very different and one is much more powerful at saving you money than the other.
So which one is better? Should you try to get every tax credit possible? Or are you better off using every tax deduction available? In this post, I’ll clear all this up so you can save the most money possible on your taxes.
Tax Credits vs. Tax Deductions
Before we can talk about which one of these tax savings you should focus on, we first have to understand how each one works.
- Tax Credits: This is a dollar-for-dollar write off on your taxes. For example, if you are able to take a $1,000 credit, you reduce your income by $1,000.
- Tax Deductions: This is a write off on your taxes that is proportional to your tax bracket. For example, if there is a $500 tax deduction and you are in the 25% tax bracket, you can write off $125.
Let’s look at each of these in another example. Let’s say you are single and earn $50,000 annually. This puts you into the 25% tax bracket. You have $2,500 worth of student loan interest you paid during the year.
As it stands, student loan interest is a tax deduction. Since you paid $2,500 and are in the 25% tax bracket, you can claim a deduction of $625. This reduces your taxable income from $50,000 down to $49, 375.
Now, let’s assume that student loan interest were a tax credit instead. In this case, the entire $2,500 would be written off as a credit. This reduces your taxable income from $50,000 down to $47,500.
As you can see, a tax credit is much more valuable than a tax deduction. Unfortunately the government knows this, so they limit the amount of available tax credits and allow for more tax deductions.
Available Tax Credits
Even though the IRS limits the amount of tax credits, there are some very popular ones that many tax payers can take advantage of. Here is a short list of the biggest ones as of this writing. (Note that since tax law changes frequently, be sure to consult your tax advisor to make certain these are still available.)
- Earned Income Tax Credit
- Child and Dependent Care Credit
- Lifetime Learning Credit
- American Opportunity Tax Credit
- Savers Credit
- Advanced Premium Tax Credit
- Adoption Credit
- Elderly or Disabled Tax Credit
In each of these cases, there are requirements you need to meet in order to claim these tax credits. You should review all of the requirements on the IRS website.
Saving The Most On Taxes
While using tax credits are more valuable than tax deductions, this doesn’t mean you should simply focus on tax credits. Remember when it comes to your taxes, your goal is paying the least amount you are legally obligated to pay.
This means taking advantage of both tax credits and tax deductions. Doing so will ensure you are not paying more in taxes than needed. And as a result, you will get a larger refund from the IRS.
Overall, tax credits are a better deal for taxpayers than tax deductions. But smart taxpayers will use both to their advantage so that they pay the least amount of money in taxes possible.
So the next time you sit down to complete your taxes, you will know the difference between credits and deductions and can make certain you are using both to save yourself the most money possible.