Introduction to Tax Credits

Assume you are at a cocktail party and the issue of taxes comes up. What is the first thing people complain about besides paying them? The number one complaint is the government is getting rid of all the tax deductions. This bitterness makes sense because tax deductions are the primary tool taxpayers have for knocking down their gross income when figuring out there taxes. The problem with this argument, however, is most people don’t take into account the value of tax credits

With any introduction to tax credits, it is important to understand a few things. First, a tax credit and tax deduction are two different things. Second, a tax credit is FAR more valuable than a tax deduction in most cases. Third, most people fail to claim tax credits that are available to them and overpay their taxes. Okay, let’s get to the nitty gritty.

Tax credits are different and far more valuable than tax deductions. A tax deduction is used to lower your gross income with the result being called your adjusted gross income. In simple terms, you total all of your earnings and reduce that amount by your total tax deductions. You then take the remaining figure and find out how much you owe by applying it to the tax table provided by the IRS. A tax credit works a little differently.

With tax credits, you follow the same approach as above. Figure out your gross earnings. Subtract all deductions. Figure out the tax owed by taking the remaining figure and applying it to the relevant tax table. Here is where it gets really good. Once you have the exact amount of tax you owe the IRS, you reduce that amount by any tax credits you are going to claim. If you owe $10,000 and claim tax credits for $4,000, you end up writing a check for $6,000. Let’s look at a practical example

The government wants to get us off oil. To change our gas guzzling behavior, it promotes the purchase of hybrid cards through tax incentives. In 2004, you could claim a $2,000 tax deduction if you purchased one. Sales did not meet the government objectives, so it made a huge change in 2005. The IRS was instructed to convert the $2,000 tax deduction into tax credits ranging from $500 to a couple thousand dollars depending on the vehicle. Now you can take up to $2,000 off that check you were going to write to Uncle Sam if you go out and buy a hybrid. See the value in tax credits now?

Maximizing your deductions is a smart move when paying taxes. More important, however, is making sure you claim all tax credits available to you.

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