"Don't assume that the raw dollar amount of a deduction is better than a smaller credit," says LeValley-Cocovinis.
She suggests you use this shorthand method to get an idea of how much a deduction will reduce your tax bill: Multiply the deduction dollar amount by your marginal tax rate (the rate your last dollar is taxed at, as discussed in lesson No. 4). This calculation shows that a $400 deduction equals a $100 credit for a filer in the 25-percent bracket.
You can do the math in reverse, too. To get the deduction equivalent of a $400 tax credit, this filer would divide the credit amount by 25 percent and discover that he would need $1,600 in deductions to get the same tax savings.
7. Exclusions add up to tax savingsOur tax system offers yet another way to reduce your taxable income. In some situations, you can exclude some of your income from taxation.
Many taxpayers get to do this at work through their cafeteria plan benefits. In these cases, you spend your money on a benefit, such as making contributions to a flexible spending account or paying your portion of health-care coverage. Your money, however, goes toward these benefits before your employer computes your payroll taxes. Your salary amounts used for these benefits are, in effect, excluded from your taxable income.
Tax savings in this case aren't limited to federal income taxes. You also escape the employee's 7.65-percent portion of Social Security taxes on the excluded money, says LeValley-Cocovinis, and "a lot of states follow the federal rules and also don't tax that money, so you get an additional bump."
In most cases, says LeValley-Cocovinis, when given the choice between a deduction and exclusion, "go for the exclusion over the deduction." This means, for example, you generally will come out ahead on taxes if you opt to put money in a medical flexible spending account (an exclusion) rather than trying to amass enough medical expenses to itemize on your tax return.
You'll also find that some federal tax credits contain exclusion provisions. They are used as a way to reduce overall holdings for estate purposes (the annual gift-tax exclusion, for example, allows you to give away in 2009 up to $13,000 each to as many individuals as you would like with no tax liability for either giver or recipient) and, on the state and local levels, as a means to lower your annual property tax bill by eliminating part of your home's assessed value from the computation (homestead exemptions).
And speaking of homes, the federal tax law governing the sale of a personal residence provides the biggest exclusion most taxpayers will encounter. Tax law says you don't have to count $250,000 (twice that if you're married filing jointly) of your sale profit as taxable income.
8. Stealth taxes sneak inEven when you do all you can to reduce your adjusted gross income, sometimes it's not enough.
Many deductions and credits aren't available to taxpayers who make more than a specific AGI. Exceed the limit set for a particular tax break, and you won't be able to claim it.
And personal exemptions and total itemized deduction amounts are reduced or even eliminated for high-income taxpayers. "When you reach the top of the progressive system, you start to lose things," says LeValley-Cocovinis.