As we near the end of the year, you’ll probably see a lot of websites talk about some smart year-end tax moves you should make. All of the tips fall into one of two categories – accelerating tax deductions and credits or delaying income. When you start reading the tips in the first category, accelerating tax deductions and credits, it’s important to understand the difference between the two because it could impact your decision.
What’s the difference between a tax deduction and a tax credit? You might think the two are interchangeable but they aren’t. A tax deduction is something that reduces how much taxable income you claim. A tax credit is something that directly reduces how much tax you owe.
Tax Deduction: Mortgage Interest Deduction
Let’s take an example of a popular tax credit – the mortgage interest deduction. If you own a home and have a mortgage, you are making monthly payments towards the loan. Part of your payment is towards principal and part of it is towards the interest on the mortgage loan. In general, your mortgage interest will be tax deductible. Let’s say you make $5,000 in mortgage interest payments for 2009 and you earn $50,000 a year. You are able to deduct $5,000 from your income so that it appears, for tax purposes, that you only made $45,000 a year.
Since you are in the 15% marginal tax bracket, according to the 2009 Federal income tax bracket, your actual savings is 15% on the $5,000 – or $750. You can measure the financial benefit of a deduction by multiplying it by your marginal tax rate.
Let’s compare the mortgage interest deduction to the Hope credit. The Hope credit is an education credit that allows you to claim 100% of the first $1,2000 of qualified education expenses and 50% of the next $1,200, for a total of $1,800. A credit is a straight reduction of your taxes owed, rather than a reduction of your taxable income, so the $1,800 credit means you pay $1,800 less on your taxes.
For refundable tax credits, if you would otherwise owe less than $1,800, you get the difference back as a refund! Unfortunately, the Hope credit isn’t a refundable tax credit (there are only five: the Additional Child Tax Credit, the Earned Income Credit, the Excess Social Security and RRTA Tax Withheld Credit, the First-time Homebuyer credit, and the Health Coverage Tax Credit).
For an intents and purposes, the financial benefit of a tax credit is the value of the tax credit.
Which Is Better?
It’s really not a question of which one is better because you don’t get to choose what a particular expense is. Something that is a tax deduction can’t be a tax credit, so you never really have a choice in the matter! If you’re starting to think that tax deductions are bad, because they only reduce your income, and tax credits are always better, there are some cases where it’s a little better if something is a tax deduction.
The Roth IRA account is a great retirement account only available to those who earn under a certain income limit. For single filers, if you earn more than $120,000, then you won’t be able to contribute to a Roth IRA. You can use tax deductions, such as contributions to a qualified 401(k), to reduce your adjusted gross income so that you would be eligible for the Roth IRA. Tax deductions, unlike tax credits, can be used in this way to open up some opportunities otherwise unavailable to you.
It’s not uncommon for people to mistake the two because IRS terminology was never designed to be clear and easy to understand. It’s usually only important for you to understand it when you’re making year end tax decisions because you won’t be able to mix up the two when you prepare your taxes, especially if you use a tool like TurboTax.