Money Girl explains tax credits and how they help you pay less tax and save more money.
When you consider how you’d like to spend your hard-earned paycheck, paying taxes probably doesn’t come to mind. But did you know that they’re probably your largest expense, next to housing?
Since taxes take such a big bite out of your income, it’s smart to cut them every way possible. This is the first episode in a 2-part series about how to legally pay less taxes and save more money..
How Many Taxes Do You Pay?
I’m sure you’ve heard the saying, "In this world nothing is certain except death and taxes." Benjamin Franklin is credited for that famous phrase. I’ve often wondered what he’d think about all the dozens of taxes we have to pay these days.
There’s federal income tax, state tax, sales tax, gasoline tax, capital gains tax, estate tax, gift tax, food tax, alcohol tax, property tax, and business tax, just to name a few. Taxes are baked into just about every financial transaction, no matter if you’re earning or spending money.
Of course, you should never do anything illegal to avoid paying taxes. But there’s nothing wrong with making sure that you don’t overpay. Even the Internal Revenue Service (IRS) encourages taxpayers not to pay more in taxes than the law requires.
What's the Difference Between a Tax Deduction and a Tax Credit?
So what’s the big secret to paying less tax? It’s simple: claim every tax deduction and tax credit that you’re eligible for. Deductions and credits can reduce the total amount of income tax you have to pay. Here’s the difference between the two:
A tax deduction reduces how much taxable income you claim. A tax credit reduces how much tax you owe dollar for dollar.
Tax deductions reduce the amount of your income that’s subject to tax. For instance, if you contribute $2,000 to a traditional retirement account, you generally are allowed to deduct that amount from your income. In other words, if your gross income is $50,000, having a $2,000 deduction means that you’re only taxed on $48,000. That would save about $500 in federal taxes for a single filer in 2013.
Tax credits are even more powerful than deductions because they reduce the actual amount of tax you must pay. For instance, if you’re a single filer in 2013 with gross income of $50,000, you pay about $8,000 in taxes. However, if you qualify for a $2,000 tax credit, you only have to pay $6,000.
So, a tax deduction reduces how much taxable income you claim. A tax credit reduces how much tax you owe dollar for dollar. In other words, having a $2,000 tax credit actually saves you $2,000, while having a $2,000 tax deduction only saves you a percentage of that amount based on your effective tax rate.
Some tax credits are even refundable, which means they can reduce your taxes below zero and allow you to get a tax refund.
5 Common Tax Credits for 2014
In this episode, we’ll cover 5 common tax credits that you might qualify for in 2013 and 2014. Then in Part 2 of this series, you’ll learn how to take advantage of every possible tax deduction for your situation: