Deductions and credits. You hear these terms tossed about at tax time or when a major legislation goes through, but not everyone understands the difference between the two and how they affect your tax bill.
A tax deduction is the result of an expense or exemption being subtracted from your gross income or Adjusted Gross Income (AGI) before calculating your tax liability. After subtracting above-the-line deductions from your gross income, the resulting figure is your AGI. Either the standard deduction or the sum of your itemized below-the-line deductions is then subtracted from your AGI to calculate your taxable income. Your taxable income determines your tax bracket, and from there your tax liability is calculated.
A tax credit is a dollar amount subtracted directly from your tax liability. Your AGI is used to determine your eligibility for certain credits. Credits vary. Some credits are refundable, meaning that if the credit reduces your tax liability to less than zero the remainder is issued as a tax refund. Some credits allow any remainder to roll over for the next tax year, and some are nonrefundable and will not reduce your liability below zero. Available tax credits frequently change year to year as Congress renews them or creates new ones and allows others to expire.
While both lower your tax liability, the result of this system is that a $1000 tax credit is worth more than a $1000 tax deduction. If you are in the 25% tax bracket, a $1000 tax deduction brings down your tax liability by $250. A $1000 tax credit lowers your final tax bill by $1000.
We will discuss your possible deductions and credits with you at your tax prep appointment to be sure you claim those for which you are qualified. Call 860-216-2195 to schedule.