If you had a choice, is it better to save money on your taxes in the form of a tax break upfront or as a reduction of your overall tax liability? The answer to this question depends on your circumstances and the impact that tax credits and tax deductions have on your overall tax bill. It is important to understand the difference between credits and deductions as you look at your tax situation from year to year. Determining whether credits or deductions are the best for your situation can be the difference between reducing your taxable base or reducing your tax liability. Knowledge is power, and knowing this key difference could save you even more money.
A tax credit is a reduction of your tax liability on a dollar-to-dollar basis; if you take a tax credit of $1000, you pay $1000 dollars less in taxes. Tax credits may be used to reduce your overall tax liability, although they may not be enough to completely eliminate the amount owed for certain high income earners. Typically a credit must be used in the year in which it is applied to your tax filing and any excess amount may not be carried over to subsequent years.
If you were to look at the commonly used Form 1040 for individual tax filers, you would see that credits are applied to your adjusted gross income, or AGI. This is performed after certain deductions are taken, which may be a standard deduction or itemized deductions that are accounted for on a separate form (i.e. Schedule A).
Whereas your tax credits are used to reduce your overall tax liability, deductions reduce your taxable income; tax deductions are based on your income bracket, so you deduct an amount in proportion to what you make each year. Lowering your taxable income can result in a lower tax liability after certain exemptions are taken and any tax credits are applied. Unlike tax credits, certain deductions may be carried forward for a certain number of years, if the amount of deduction exceeds the limit that can be taken for a given year.
A good example would be deductions for charitable contributions made within a given year. Current rules permit you, as an individual filing singly, to deduct an amount equal to 50% of your AGI for contributions made to certain public charities or 30% of your AGI for contributions made to private foundations and other charitable organizations. If the amount given exceeds either 30% or 50% of your AGI, you are permitted to carry forward the unused amount for a period of up to 5 years.
A careful review of your tax situation will help you determine when it is better to take a tax credit versus a tax deduction for a certain items, such as education. The American Opportunity Tax Credit (AOTC), a modification of the Hope Tax Credit, allows a you to take a credit of $2,500 (per student) if you are an individual making a modified AGI of $80,000, or $160,000 for a couple filing jointly. This modification to the Hope Tax Credit (which extends through 2017) allows certain higher income earners to qualify where in the past this was not the case. The AOTC compares to the Schedule A deduction available for tuition and fees. This deduction, which is again available to the same income classes as the AOTC, can reduce your taxable income by up to $4,000. If the amount you would save on your taxes by claiming the AOTC is less than the amount you would save by taking the Schedule A deduction, the deduction is the better option. In general, tax credits are the more valuable tax break.
Remember that a credit will reduce your overall taxable income, while a deduction will reduce income subject to taxation. Choosing between taking a tax deduction or a claiming a tax credit can be tricky, so be sure to contact an R&G Brenner tax professional if you have questions.