Taxpayers have gotten a lot smarter over the years. Once, the filing-day tax cry was "Deduct!"
Now folks know they usually can save more tax dollars by claiming tax credits.
There are several reasons why credits tend to come out on top when you're looking for tax savings.
The main reason is that in tax parlance, "credit" means the same thing as it does when you see that line item on your charge account statement. A tax credit is a dollar-for-dollar benefit. The credit is applied to your final IRS bill, meaning you get money back or don't have to pay Uncle Sam as much.
A tax deduction, however, reduces the taxable income upon which your final tax bill is figured. Less income usually means a smaller tax bill but generally not as much as does a credit.
You can get an idea of the value of credits by comparing the tax savings of an ostensibly larger deduction to that of a credit.
The tuition and fees deduction offers eligible taxpayers a $4,000 deduction. Another tax break for educational expenses, the Lifetime Learning credit, is only half that. But don't be so fast to opt for the deduction.
With the $4,000 deduction, you subtract that amount from your earnings to reach a smaller taxable income amount; $50,000 then becomes $46,000. But that $46,000 still leaves you in the 25 percent tax bracket, meaning that your $4,000 deduction is worth, when you finally compute your tax bill, only a fourth of its dollar value: $4,000 x 25 percent, or $1,000.
The $2,000 Lifetime Learning credit, however, is subtracted from your final tax bill. So if you owed $2,200 on your $50,000 income, the credit will knock that down to only $200.
Credit ebb and flowIn recent years, as lawmakers have looked to provide more breaks for constituent taxpayers, a number of credits have been added to the tax code. Congress sometimes adds them temporarily; other times, it makes the breaks permanent.
But in each case, the guiding principal is the same. While deductions, whether itemized or the standard amount, help you whittle down the amount of income upon which your tax bill is figured, credits will cut your final IRS tab dollar-for-dollar, and in some cases even provide you a refund after you've zeroed out your bill.
And some popular core credits have stood the test of time and taxpayers. These include credits to give you a break for caring for, or simply having, children, saving for retirement, furthering your or a family member's education, and even recouping Social Security overpayments.
Refundable versus nonrefundableAlthough credits generally are preferable to deductions, some credits have greater tax appeal than others.
There are two types of tax credits: refundable and nonrefundable. Again, this is a case where the IRS actually means what it says.
A refundable credit means that the tax break will get you money back from the IRS even if your tax bill is zero. For example, you owe $500 and can claim a $1,000 tax credit. If that credit is refundable, you'll get $500 back as a refund.
However, if the credit is nonrefundable, you'll only be able to use the credit to zero out your tax bill, but no more than that. The excess $500 from the credit is lost.