How to Calculate Tax Credits
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 even be listed on a separate form, such as a Schedule A. Maximizing those deductions allows you to reduce your overall taxable income. Your tentative tax due is calculated from your taxable income.
Credits are applied to your tentative tax and reduce the overall tax due on a dollar for dollar basis. Popular credits for 2010 include the Making Work Pay Credit, the American Opportunity Credit and the Earned Income Tax Credit.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 initial tax, dollar for dollar, from $2,582.50 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 are eligible for a refund. Deductions are never refundable since they are a reduction in your taxable income: 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.