Now that tax season is upon us, many look for ways to reduce their taxes (hopefully most of you took advantage of some tax deductions before the end of the year). There is usually a mad rush to claim all of the deductions one can in order to reduce their tax liability. But are tax deductions really worth it?
Before getting into this discussion, I need to make a clarification between a tax credit and a tax deduction.
This is an amount of money a taxpayer is able to subtract from the amount of money they owe the government. It is a dollar for dollar match. For example, the child tax credit reduces your taxes by the amount of the credit.
A tax deduction is an amount of money that lowers your tax liability by reducing your taxable income. For example, you can deduct student loan interest can be written off of you taxable income, thus reducing your tax liability.
Why Credits Are Better
If you are like many reading this, you may still be confused about what the difference is between the two. Don’t worry, as taxes are a complex topic and credits and deductions are as well. The key as to why credits are better are for the dollar for dollar match they provide. A tax deduction on the other hand, only reduces your taxable income and thus your tax liability proportionally, depending on the tax bracket you are in.
Real Life Example
Let’s use an example to clear this up. John makes $50,000 per year. This puts him squarely in the 25% tax bracket. As he is determining his taxes, he realizes he paid $2,000 in student loan interest last year, thus he gets a tax deduction. How much is his tax deduction? It is not $2,000. His tax deduction is the $2,000 in student loan interest he paid multiplied by the 25% tax bracket he is in. John can deduct $500 from his taxes. So, at the end of the day, John now has a taxable income of $49,500 (his original $50,000 less the $500 student loan deduction).
Mary on the other hand, also makes $50,000 per year and is in the 25% tax bracket. She does not have any student loans to reduce her taxes. However, there was a program this year where if you bought “green” appliance, you could take a credit for the amount of the appliance on your taxes, up to $1,000. Mary bought an energy efficient dishwasher that qualifies. It cost her $1,000. Because this is a credit, Mary can credit her taxable income by $1,000 (the amount she paid for the appliance). At the end of the day, Mary now has $49,000 in taxable income (her original $50,000 less the $1,000 credit).
Hopefully this shows you that any deduction you claim on your tax return only reduces your tax liability by the tax bracket you are in. If you are in the 25% tax bracket, every dollar you spend that is eligible for a deduction allows you to write off $0.25 of that dollar on your taxes. If you are in the 10% tax bracket, $0.10 of every dollar you spend that is eligible for a deduction will go towards reducing your tax liability.
Why Deductions Are Misleading
Even though you are getting a tax deduction, are you really saving any money? So many argue that you should take your time paying off your student loans because the interest you pay is tax deductible. That is true, but not every dollar. At most it’s $0.35 of every dollar because the highest tax bracket right now is 35%. Added to that, the majority of tax deductions have limits to not only the amount you can deduct, but also depend on what you earn. If you earn too much money, you cannot deduct any student loan interest. If you don’t earn too much and can claim the deduction, you can only deduct up to $2,500 in a year.
Revisiting John above, he is “saving” $0.25 of every dollar in interest he pays on his taxes. I will grant you that it is better than nothing, but wouldn’t you rather pay off the loan and be able to invest 100% of the money instead?
To put another way, in the end he paid $1,500 in student loan interest (the $2,000 he actually paid less the $500 he is able to deduct off of his tax return). He paid $1,500 in interest!
I am all for saving as much as you can on your taxes. But don’t be misled thinking that deductions will reduce your tax liability dollar for dollar. They won’t. Only credits do that.