Which Is Better: A Tax Credit or a Tax Deduction?

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Pop Quiz: Taxes

By Maryalene LaPonsie

Money Talks News finance expert Stacy Johnson has already been thinking about taxes, so he went to Times Square to see how well average people understand tax time basics. How well do you think you can do on this quick quiz?

You miss the April 15 filing deadline. The government is going to fine you beaucoup bucks, right?

Maybe not. The government does assess both failure-to-file and failure-to-pay penalties, and those aren't cheap. The failure-to-file penalty is 5 percent of your unpaid taxes each month, and it begins accruing April 16. The failure-to-pay penalty isn't quite so hefty, coming in at 0.5 percent of your unpaid taxes. You can read more about the penalties on this IRS tax tip sheet.

However, the failure-to-file penalty applies only to tax returns on which you owe money. If you're due a refund, there's no penalty for late filing. However, the IRS says you don't want to wait too long, or you could lose your refund entirely. Here's what the agency says on its website: "There is no penalty for failure to file if you are due a refund. But, if you wait to file a return or otherwise claim a refund, you risk losing a refund altogether. An original return claiming a refund must be filed within three years of its due date for a refund to be allowed in most instances."

Which is better: A tax credit or a tax deduction?

A tax credit wins every time. The reason is simple. A tax deduction lowers your taxable income, while a tax credit lowers your tax bill dollar for dollar.

Here's an example, with rounded numbers for simplicity. Let's say you have a $50,000 income and fall into the 25 percent tax bracket. A $1,000 tax deduction reduces your taxable income to $49,000, which would drop your tax bill by $250. However, if you were to have a $1,000 tax credit, your tax bill would be reduced by $1,000. You come out $750 ahead with a tax credit.

Tax credits come in two types: refundable and nonrefundable. Let's say you owe $500 in taxes and have a $1,000 nonrefundable tax credit. In that case, your $500 tax bill would be wiped out and that would be the end of the story. But if you have a $1,000 refundable tax credit, your tax bill would be wiped out, plus you would get $500 back from the government. This IRS page has more on credits and deductions.

True or false? Someone with a multimillion-dollar income can have a lower tax rate than someone earning $100,000.

Oh, you knew this one was true, right? The Internet is full of articles about how the super rich manage to lower their effective tax rate to less than what more average Americans might pay.

While every situation is different, a major reason for the lower tax rate among the wealthy could be how they earn their money. Rather than going to a 9-to-5 job and pulling down a salary, the top income earners may be bringing in their money from the sale of stocks and other assets. Money from those sources, known as capital gains, is taxed at a flat 20 percent for the highest earners. (It can be lower for other folks.) This IRS publication explains more.

Do you need an accountant to get your taxes done right?

Nah, you'll probably be fine on your own. Today's tax preparation software makes it easy to complete your own tax return even if you're self-employed or have cashed in some investments. Personally, I'm a fan of TurboTax, but you have plenty of options from which to choose. If your income is below $60,000, you can even use some programs to file your taxes for free. The IRS Free File site has links to participating software providers.

Of course, tax professionals have their place. If you own a business or have a complicated tax situation, using a pro can be money well spent. If you're not sure whether you need a tax preparer, remember that many online tax prep sites will let you prepare your return at no cost and charge you only when you file. You can try these sites first, and if you find yourself confused or the numbers don't seem to add up, you can easily shift to an offline preparer without paying a dime to the website.
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