Tax Deductions vs. Tax Credits

There are 2 ways to lower the amount of taxable income you owe: tax deductions and tax credits.

Tax Deductions
A tax deduction lowers the amount of tax you owe the IRS by decreasing your gross income, which means you’ll fall into a lower tax bracket (and will therefore be taxed at a lower percent).

There are 2 categories of tax deductions:

#1 Deductions FOR adjusted gross income
These deductions simply lower your taxable income before your tax bracket is determined and aren’t affected by whether you decide to itemize your or not.

#2 Deductions FROM adjusted gross income
There are 2 types of these deductions:

• your itemized vs. standard deduction; and
• the Personal & Dependency Deduction

Itemized vs. Standard Deduction: You should select the greater of your itemized expenses and the standard deduction. The standard deduction was $10,300 for married couples and $5,150 for individuals in 2006.

Personal and Dependency Deduction: This deduction is $3,300 per person, with a limit for some individuals based on income. BOTH the itemized/standard deduction and the Personal and Dependency Deduction are taken on tax returns.

Tax Credits
A tax credit is the other way to lower the amount of tax you’ll have to pay. Tax credits are applied after your tax liability is determined. Tax credits then reduce that liability dollar for dollar, meaning that they are not affected by your tax rate.

For example, a $1000 tax credit provides the same savings to someone in the 15% tax bracket as well as someone in the 25% bracket.