Tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket.
For instance, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).
On the other hand, tax credits provide a dollar-for dollar reduction of your income tax liability. For instance, a $1,000 tax credit actually saves you $1,000 in taxes. A tax credit is always worth more than a dollar-equivalent tax deduction, because deductions are calculated using percentages. Referring to the numbers above, you can see that a $1,000 credit offers $750 more in savings than a $1,000 deduction.
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There are two main types of tax deductions: the standard deduction and itemizeddeductions. A taxpayer must use one or the other, but not both. It is generally recommended that you itemize deductions if their total is greater than the standard deduction.
- The standard deduction is a dollar amount that reduces your taxable income. It is usually adjusted for inflation every year. Your standard tax deduction amount is based on your filing status, and it is subtracted from your AGI (adjusted gross income).
- If you do not qualify for the standard tax deduction, you may choose to itemize your deductions. A taxpayer will also typically itemize tax deductions if it offers them more benefits than the standard deduction (i.e., when the total amount of qualified deductible expenses is greater than the standard deduction). Certain itemized deductions are based on a minimum (or “floor) amount. This means that you can only deduct amounts that exceed the specified “floor.” There is also an income limit for taxpayers who itemize.
Alternatively, above-the-line deductions are taken before your AGI is calculated (instead of after, like the other tax deductions). Above-the-line deductions are subtracted from your gross income, and the resulting number is your AGI. Above-the-line tax deductions apply whether you itemize or not.
It’s in your best interest to take advantage of every tax credit and deduction available to you.
Understanding your financial position together with your personal situation will help you determine which tax credits and deductions you can benefit from.