As we usher in the New Year, it’s time to shift your focus towards tax planning. A crucial aspect of this process involves understanding the distinctions between tax deductions and tax credits. Having a clear insight into these elements will help you enhance tax efficiency, ultimately contributing to your household’s wealth.
TAX DEDUCTION
Tax deductions are essentially those items that minimize your taxable income by being subtracted from your gross income, thus modifying it. There are two primary kinds of deductions. ‘Above the line’ deductions are determined on the first part of your Form 1040, forming your adjusted gross income. The other set of deductions lie on the second part of the Form 1040, which include the standard deduction or your Schedule A deductions. These secondary wave of deductions further shrinks your income and helps in arriving at your taxable income.
TAX CREDIT
Contrary to tax deductions, a tax credit doesn’t reduce your taxable income but lessens the total tax amount you need to pay. Once you’ve determined your taxable income after accounting for all deductions, you refer to tax tables to calculate your tax liability. After this step, you start introducing tax credits to minimize the final pay-out. A tax credit equalizes dollar for dollar which is akin to utilizing a gift card against your outstanding balance. If your tax credits exceed your liability, you can end up with a negative tax balance, leading to a refund from the government.
Tax credits are generally seen as more beneficial than tax deductions as they offer a dollar for dollar deduction rather than just lowering your taxable income.
TAX ADVANTAGES
It would be wise to keep track of eligible expenses throughout the year to maximize tax deductions and credits. Ensure to retain all relevant receipts and documents to support your claims in case of an audit. As you approach 2011, factor in tax credits and deductions in your financial plan in order to accumulate them year-round rather than scrambling to calculate them at year-end.
To ensure you’re making informed decisions, consider consulting with a qualified tax advisor.
