by Ryan McKeown, CPA, CFP®, Associate Financial Advisor,
Wealth Enhancement Group

A lot of individuals tend to confuse the difference between a “tax deduction” and a “tax credit.”  It is a reasonable misunderstanding since it seems as though our government institutes an overwhelming amount of “deductions” and “credits” every year.

A tax deduction simply reduces your taxable income, the tax savings calculated by multiplying the amount of your deduction by your marginal tax rate.  For example, let’s say you were eligible to make a $2,000 deductible contribution into a Traditional IRA account and were in the 25% marginal tax bracket.  By taking $2,000 times 25%, your tax savings would be $500.

A tax credit reduces your tax liability directly. For example, the “American Opportunity Credit” (an education credit put in place for 2009 and 2010 by the American Recovery and Reinvestment Act, otherwise known as the “stimulus” bill) allows eligible individuals and families with qualified higher education expenses to receive a 100% tax credit for the first $2,000 they spend on such costs, and a 25% tax credit for the second $2,000 spent. For purposes of this example, let’s say an eligible family spends $2,000 on qualified higher education expenses. That family would receive a $2,000 tax credit, meaning that the actual tax savings would be $2,000. Remember in the deduction example, spending $2,000 only saved $500 in actual taxes. With the tax credit, spending $2,000 saved $2,000 in actual taxes.

Tax credits can be more desirable than tax deductions; however, sometimes tax deductions can be more favorable than credits depending on your personal situation. We recommend visiting with a tax professional to determine how to best take advantage of all of the tax savings you could be eligible for.