Actually, that’s kind of a trick question – for two reasons. First, the two are not interchangeable. They are two separate designs the IRS has in place to reduce the amount you could owe on your taxes. A tax credit reduces how much tax you owe while a tax deduction reduces how much income you claim.
Second, in most cases, you don’t get to choose which one to apply to your tax return. You may qualify to take a certain deduction but not qualify for a particular tax credit. While the credit is actually worth more dollar-for-dollar, it’s also more difficult to qualify for. The worth of the deduction is dependent upon your tax bracket.
Here’s a hypothetical example (for example purposes only):
Let’s use a common tax deduction – the mortgage interest deduction, which you qualify for if you own a home and you are making monthly payments towards your mortgage. Interest you pay on this loan is tax deductible as long as your itemize. Say you paid $5,000 in mortgage interest payments and you made $50,000 for the year. Once you itemize, you are then able to deduct $5,000 from your income, claiming only $45,000 taxable income. According to the 2013 Income Tax Bracket, your marginal tax bracket is 15%. Your actual savings is 15% on the $5,000 – or $750 ($5,000 x 15% = $750).
Let’s look at a common tax credit – the American opportunity education credit, which was extended through 2017 under the Taxpayer Relief Act of 2012 and replaced the Hope credit. The American opportunity tax credit includes expenses for course-related books, supplies and equipment that are not necessarily paid to the educational institution. Say you qualified for the maximum credit of $2,500. And you end up not owing any taxes, well then you would actually get $1,000 back because 40% of this credit is refundable.
A tax credit doesn’t always win over a deduction either. There are a few cases where it’s better to have a deduction than a credit. Take, for example, the Roth IRA, a retirement account available to those who earn under a certain income limit. You might choose to use a tax deduction, such as contributions to a qualified 401(k) plan, to reduce your income and, therefore, become eligible for a Roth IRA account (which, by the way, you can’t deduct).
It’s important to note, though, that each tax situation is different. How each of these options impacts you specifically will depend on a variety of classifications. The best course of action is to focus your research credits and deductions that you may be eligible for. Then do the math to calculate the best way to maximize them.
Of course, the contact info for a reliable tax preparer is probably the fastest and easiest method. Where do you think I get my information from?