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Deductions vs. Credits
One of the best ways to understand the meaning of a deduction in taxes is to compare it with tax credits, another tax category that benefits taxpayers. Deductions and credits are both good news for taxpayers, as both reduce your tax obligation. However, their actual effects on your taxes are slightly different. Tax deductions reduce your taxable income amount, which reduces your amount of taxes owed. A tax credit is an amount credited toward your tax obligation. It more directly lowers your amount of taxes owed.
Deduction and Credit Examples
To more clearly understand the difference between a deduction in taxes and a tax credit, consider how each can be applied. If you paid $7,000 in mortgage interest during the 2010 tax year, for instance, you can likely get a tax deduction for this $7,000 amount. If your income before the deduction is $60,000, your new taxable income after the deduction is $53,000. Thus, you are taxed on the $53,000 as opposed to your income of $60,000 before the deduction.
Credits are applied after taxes are determined. If you claim a $1,000 qualified child tax credit, the maximum allowed per child by the IRS, that amount directly reduces your tax obligation. If you owed $2,000 before the credit, your new obligation is $1,000. If you had a refund due of $2,000, your new refund amount is $3,000.
Standard vs. Itemized Deductions
A basic consideration when filing taxes
is whether to use a standard deduction amount or to itemize deductions. Your standard deduction amount is established each tax year by the IRS as adjusted for cost of living. Standard deductions for people 65 and older and those who are blind are added to the base deduction. Taxpayers who have significant deductions often itemize deductions when total deductions exceed the standard amount.
Standard Deduction Limitations
Certain taxpayers are not eligible to receive standard tax deductions, according to the IRS. Married people filing separately from a spouse who itemizes deductions cannot opt for a standard deduction. Individuals designated as nonresident aliens or "dual status" during any part of the tax year can't claim a standard deduction. Someone filing for a period of less than 12 months is also not eligible.
Common Itemized Deductions
Itemizing your income tax deductions makes sense when you're unable to use the standard deduction or when you financially benefit from a high level of available deductions. If you have significant amounts of deductible expenses through common deductions, you might exceed the standard deduction threshold. Large uninsured medical or dental expenses, mortgage interest and property taxes, non-reimbursed employee business expenses, casualty or theft losses and large charitable contributions are all major deductions that could put you over the amount available through the standard deduction. Many tax accountants and online tax preparation software programs allow you to enter your individual deductions and then determine whether the standard or itemized deductions work better for you.