Financial Resource Center

Money Management


101: Tax Deductions and Tax Credits

by Jeremiah Tucker / February 8th, 2016


Because we tend not to think much about taxes until tax season is upon us, every year can require a bit of a refresher.

It's best to think of tax time as settling up your bill with the government, because you're actually paying taxes all year long. Before you even get a paycheck, income taxes are taken out of it. When you file your tax return, what you're really doing is determining if you've paid Uncle Sam too much or too little.

That's why if you get money back from the government after filing your taxes, it's called a "refund." To ensure you get the biggest refund possible, it helps to claim as many deductions and tax credits as you qualify for.

But what, exactly, are they?

Deductions

There are a few different kinds of deductions, but they all do the same thing—reduce your taxable income. So, for instance, if you make $40,000 a year but you have a $500 deduction, you will only pay taxes on $39,500 a year.

Here are the different kinds of deductions:

Adjustments to gross income: These are also called above-the-line-deductions. They're very specific and limited deductions available to anyone, and they're used to determine an individual's adjusted gross income—which is the taxable income you will use for your other deductions. Your adjusted gross income is the first calculation on the standard 1040 form—the deductions are items 23-35.

Standard deductions: This is the amount any tax payer can subtract from his or her adjusted gross income. For 2016, the standard deduction for single or married people filing separate returns is $6,300, for married couples filing jointly it's $12,600, and for head of households its $9,300. This is the easiest deduction to select.

Itemized deductions: This is what most people are talking about when they talk about tax deductions or "writing that off." If you choose to itemize, you can't take the standard deduction. Itemizing makes sense if you have enough qualifying deductions that they'll reduce your taxable income more than the standard deduction. One big itemized deduction that greatly reduces your taxable income, for instance, is your home mortgage interest.

Other common examples of itemized deductions are qualifying medical and dental expenses, state and local income taxes paid during the year, and charitable donations. If you want to make sure you're taking all the deductions you qualify for, it's often best to have your taxes prepared by a professional.

Tax Credits

A tax credit is almost always better than a deduction because it reduces your tax bill dollar for dollar. A deduction only reduces the amount you pay taxes on.

Thus, a $100 tax credit entitles you to knock $100 right off your tax bill, or if you don't owe any more, it's $100 in your pocket. Whereas with a $100 tax deduction, you subtract $100 from your taxable income, so if you're in the 28% tax bracket, a $100 tax deduction only results in $28 in tax savings.

An example of a tax credit is the child tax credit, which pays families up to $1,000 for qualifying children less than 17 years old.