What are Tax Deductions and Tax Credits?

The United States tax tax system is way too complicated and is hard to understand if you are not a tax professional. The tax structure is filled with tax deductions, tax credits, standard deductions, tax brackets, filing statuses, a ton of other complications. It is crucial that you familiarize yourself with your current tax situation before you attempt to file your own taxes. In this article, I will show you the difference between tax deductions and a tax credits as well as how both of these affect your tax bracket.

Everyone seems to be talking about tax deductions and what they can deduct, but the vast majority of Americans leave tax credits out of the conversation. Tax credits are better for lowering taxes and tax brackets than any tax deductions are.

First, let’s take a look at what a tax deduction is. A tax deduction is the amount of money that you can subtract from your taxable income. In other words, it’s the amount of money that the government allows to be tax-free. Think about what kinds of deductions there are. You can get a tax deduction for giving money to a charity. The IRS will allow you to subtract that donation from your taxable income if you are eligible. The more money that is subtracted from your taxable income the lower your tax bracket will be.

We should take a closer look at tax deductions. Essentially, by spending money on a donation, you are able to subtract that money from your taxable income. This benefit is small however. You are only saving the amount of your marginal tax. Let’s look at an example. If you were in a 35% tax bracket, donated $100 to charity, and deducted that from your income taxes, you would save $35 in taxes. This is where most people get confused. Many people wrongly believe that by taking a deduction they are saving an equal amount of income taxes. According to our example, this is simply not true. Any tax deduction is only worth your marginal tax bracket rate in tax savings for the current year.

Tax credits on the other hand work differently. A tax credit is a dollar for dollar reduction in your income taxes-not your taxable income. If you had qualified education expenses, you could claim an education credit. This credit would reduce the taxes that you owe. Let’s look at an example. If you spend $1,000 on college tuition for the year, you could get an education tax credit. Also, let’s assume that before the tax credit you owe $2,000 in taxes. The tax credit will lower your taxes by $1,000, so you only owe $1,000. That is the power of a tax credit compared to a tax deduction.

Learn more about the 2011 tax brackets as well as many different tax deductions and tax credits at Tax Brackets 2011 Headquarters.