Tax time is approaching. Hopefully you are getting things organized for the end of the year, and for the start of tax season. One of the things to be mindful of when preparing your taxes — and even if someone else does the actual paperwork — is the difference between a deduction and credit. Understanding this difference can help you as you plan out your money strategy for the coming year.
A tax deduction is something that lowers your taxable income. You may have made $65,000 this year, but with deductions, you might end up with a taxable income of $47,000. The lower your taxable income, the less you pay in taxes. And, if you can get enough deductions, you can work to get your income down into a lower tax bracket. There are two different types of tax deduction that you can take:
- Figuring your AGI: The first round of deductions come as you figure out your adjusted gross income. This is figured out on the first page of your Form 1040. You start with your earned income, and then you take deductions that will result in a (hopefully) lower adjusted gross income (AGI).
- Deducting from your AGI: Once you have your AGI figured out, you flip the 1040 over and you get a chance to take some more deductions. This is where you take your standardized deduction, or itemize using Schedule A. When you are done with these deductions, you end up with your taxable income.
Now that you know your taxable income, it’s time to figure out what you owe. You tote that up, using your taxable income to figure out your tax bracket and how much you should owe. Then you start applying tax credits. A tax credit is a reduction in how much you owe. It’s like having a gift card that you can apply to the total amount of taxes that you owe. Once all of your tax credits are added up and taken away from what you should owe, you are left with either what you still owe, or a refund.
The savviest do their best to figure out how to come out at $0. This way, they have a tax balance that means they don’t owe anything at the end of the year, but they haven’t been giving the government an interest-free loan. Double check with a tax professional or visit the IRS web site to determine which tax deductions and credits you qualify for, and to learn about tax law changes, to increase your tax efficiency. And use what you learned next year as you plan your spending and saving for the coming year.