Tax credit vs Tax deduction...

What's a tax credit? What's a tax deduction? Which is "better"?

Simply, a tax deduction reduces your taxable income. A tax credit reduces your tax liability. Let's use a simple example to see the effect of each. In our example, your total income for the year is $80,000. That includes, but isn't limited to, income such as wages, interest and dividends, business income, capital gains and pensions. You are then allowed to take a standard deduction (the amount is determined by your filing status - single, married filing jointly, etc) or itemize your deductions. Common itemized deductions include mortgage interest, charitable contributions and real estate taxes. In our example, your itemized deductions are $12,000. You are then allowed another deduction, in this case called an exemption - also based on your filing status and your tax is calculated based on all of these adjustments.

Total income: $80,000
Itemized Deductions: (12,000)
Subtotal: 68,000
Exemption: ( 3,700)
Taxable Income: 64,300

Using a sample tax rate of 20%, your tax liability would be $12860.

But instead of $12,000,what if your itemized deductions were $15,000? In that case, $80,000 - $15,000 - $3,700 (exemption) = $61,300 taxable income and at 20%, your tax would now be $12260. That additional $3,000 in itemized deductions saved you $600 on your taxes. So a tax deductions reduces your taxable income, which is the basis for calculating what you owe.

A tax credit reduces the tax itself. So in our example of a tax liability of $12860, if you had a tax credit of $500, you would then owe $12360. Common tax credits include the Earned Income Tax Credit, the Child and Dependent Care Credit, the Child Tax Credit and the Retirement Savings Contribution Credit.

The reason that I've dragged you kicking and screaming through this process is because I want you to understand that large tax deductions don't translate into equally large decreases in your taxes. So if you are considering making a large charitable contribution, have your tax preparer crunch the numbers so that you know what effect this will have on your tax liability. This is especially important if you are considering the decision between donating your horse and selling it at a price well below the appraised value.

Before you make any big decisions about discretionary actions that will effect your taxes, be sure to consult with your tax preparer. It's part of their job to help you make the best choices based on your particular circumstances.