Understanding Taxes – Credits and Deductions Explained for Dummies

by Neal Frankle, CFP ®

This is a guest post about understanding taxes by Steve Cook. He is an associate at a boutique Phoenix, AZ-area tax law firm that handles various tax-related matters including estate planning, probate, business and real estate law. The firm operates a blog to which Steve regularly contributes.

Many of us in the United States prepare and file our own income taxes, but because we often do so via computerized aids like TurboTax, we rarely get into the nitty gritty of income tax concepts. One such concept is the distinction between deductions and credits. Although this distinction may seem unimportant, if not understood correctly it can lead to significant missed income tax planning opportunities.

 

understanding taxes

An Ordinary Family

In order to illustrate the difference between deductions and credits, let’s look at an ordinary family. Jack and Jill are married and have two children under the ages of 18 and a  taxable income of $65,000. We’ll examine what happens to Jack and Jill’s income taxes in two different scenarios: an additional $5,500 deduction or an additional $5,500 credit.

Deductions

In short, deductions decrease taxable income and, somewhat indirectly, the amount of income taxes owed. Although deductions are good, they will not decrease income taxes, dollar-for-dollar, in the amount of the deduction.

For example, if Jack and Jill are interested in saving money for retirement and contribute $5,500 to an IRA, it’s deductible. As a result, their taxable income will be reduced to $59,500. However, this $5,500 deduction will not decrease their income taxes by $5,500; rather, it will decrease their income taxes by about  $825.

Credits

Unlike deductions, which indirectly decrease income taxes by reducing taxable income, credits directly reduce income taxes dollar-for-dollar.

Let’s modify the example above slightly. Say Jack and Jill still have the same taxable income; however, rather than a tax deduction of $5,500, they have a tax credit of $5,500. This $5,500 credit will decrease their income taxes by $5,500.

The Decreasing Effect of Credits and Deductions

Unless tax rates exceed 100% of a person’s income (don’t laugh; it happened in Sweden not so long ago) credits will likely always be more taxpayer-friendly than deductions. However, he advantage of credits over deductions decreases the more taxpayers earn and the higher their marginal tax rates.  That’s because as a person’s tax bracket goes up, the value of those deductions goes up as well.

Although the distinction between tax credits and deductions may seem trivial, a good understanding of the effects of this distinction generally allow taxpayers to more effectively take advantage of tax planning opportunities as they arise and, in particular, those 2010 credits that are still available.

 

photo by Aficio, Flikr

 

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