- Days left

How to calculate tax credit

Taxpayers often use the terms "deduction" and "credit" as though they're the same thing, but they're not. They're actually very different terms, and being aware of the distinctions between the two can help you make good choices at tax time -- and maybe put some extra money back in your pocket.

A deduction is a reduction in your taxable income, while a credit is a reduction in your taxes due.
Deductions are calculated as part of your taxable income (you'll find taxable income on line 43 on your form 1040). They are subtracted from gross income, including wages, interest and dividends, and may be even be listed on a separate form, such as a Schedule A.

The tentative tax due is calculated from your taxable income. Credits are applied to that tentative tax and reduce the overall tax due on a dollar for dollar basis.

It's best explained with an example. Let's say you're a single taxpayer with adjusted gross income of $20,000 after your standard deduction. The tax on $20,000 is $2,582.50 (using the tax brackets, that's $835 plus 15% of the amount over $8,350). An additional $500 in deductions would result in tax due of $2,507.50

But what if, instead of deductions, you had additional credits of $500? The $500 credit would reduce that tax, dollar for dollar, to $2,082.50.

In this example, opting for the credit over the deduction resulted in a tax savings of $425. So when all else is equal, it's generally more favorable to take advantage of a credit than a deduction. This is good to know when faced with the option of claiming a deduction or a credit when both may not be allowed -- educational expenses are a good example.

Credits may also be refundable, which means that to the extent you have more credits available than tax owed, you can receive a refund. Deductions are never refundable, since it's a reduction in your income, and reducing your taxable income below zero does not result in an additional refund.

Remember: A credit is a dollar for dollar reduction in your tax due. To the extent you can maximize those credits, your overall tax burden will be reduced -- and you might even be getting some money back.

Increase your money and finance knowledge from home

Timing Your Spending

How to pay less by changing when you purchase.

View Course »

How Financial Planners go Grocery Shopping

Learn to shop smart and save.

View Course »

TurboTax Articles

A Brief History of Income Taxes

Did you know President Abraham Lincoln, one of America's most beloved leaders, also instituted one of its least liked obligations - the income tax? In this brief history of taxes, see the historical events which shaped income taxes in the United States today.

What Is a Schedule M IRS form?

Note: The content of this article applies only to taxes prepared for 2009 and 2010. It is included here for reference only. In order to take the making work pay tax credit, the IRS requires you to prepare a Schedule M with your federal tax return.

Video: Tax Filing Requirements for Children

Depending on how much money they made during the year, your children may very well have to file for taxes. Learn about tax filing requirements for children with help from TurboTax in this video on tax tips.

Add a Comment

*0 / 3000 Character Maximum