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What’s Better, A Tax Credit or a Tax Deduction?

Keep More of Your Hard-Earned Dough

I often use the word “deduction” to describe anything that might lower my tax bill. But there are actually two ways to save money on taxes: the tax credit and the tax deduction.

A tax credit is a wonderful, simple thing-it lowers your total taxes owed by the amount of the credit. So if you owed $1000 in taxes, but you had a $1000 tax credit, your net payment to Uncle Sam would be $0. Sweet. Check out this list of common tax credits on SmartMoney.com and make sure you don’t miss one.

A tax deduction is a little trickier. With a tax deduction, the amount you get to subtract from your tax bill is the tax deduction amount multiplied by your marginal tax rate. So if you owe $1000 in taxes, and you apply a $1000 tax deduction and your marginal tax rate is 25%, you get to subtract $250 from your tax bill, and you’ll end up paying $750. So what the heck is your marginal tax rate anyway? That is the percent rate where the highest portion of your income is taxed.

If you look at the way we calculate taxes, different amounts of your income are taxed at different rates. Here’s an example from the CNNMoney.com Money 101 section on taxes:

Say you are single and report $80,000 in taxable income for the 2007 tax year (filing in 2008). In accordance with the income ranges defining federal tax brackets for single filers in 2007, the first $7,825 of your income is taxed at 10 percent; dollars $7,826 through $31,850 are taxed at 15 percent; dollars $31,851 through $77,100 are taxed at 25 percent; and dollars $77,101 through $80,000 are taxed at 28 percent.

In this example, the person’s marginal rate is 28%. People also refer to the marginal rate as your “tax bracket.” I think the way we calculate deductions is pretty unfair, because as you can see, the greater your “tax bracket” or marginal rate, the more you get to subtract from your tax bill. If Cassie is in the 33% tax bracket and Helene is in the 25% tax bracket, and they both have a deductible expense of $1000, Cassie will get to subtract $330 from her tax bill and Helene will only be able to subtract $250 from hers, for the same expense.

For most people, the biggest tax deduction is the mortgage interest on their home, but as you can see, the tax benefits of home ownership are highest for those in the highest tax bracket. There’s a huge difference there - the highest earners can subtract 35% of their mortgage interest, while the lowest earners can only subtract 10%.

Of course there is the standard deduction, which is something most people take if they don’t own real estate or don’t have a lot of other deductions. For a single person in 2007, the standard deduction was $5,350, and it was double that ($10,700) for people who were married and filing jointly. Just remember, if you go for the standard deduction, you can’t apply any other deductions. If you forego the standard deduction, you can itemize (add up all your other deductions, like mortgage interest, contributions to a Traditional IRA, student loan interest, capital losses, and some business expenses). Then again, a lot of these individual deductions come with income limits, so you might not be able to take advantage of them at all.

So which is better, a tax credit or deduction? Whichever saves you the most money. If you’re in the 25% tax bracket, a $4000 tax deduction and a $1000 tax credit mean the same thing in terms of your bottom line.

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Do you love or hate doing your taxes?

Have you ever been blindsided by a giant tax bill?

Which is better - taking 0 exemptions and getting a big tax refund, or taking too many exemptions and ending up with a huge tax bill AND having to pay estimated quarterly taxes?