Which is better, a tax deduction or a tax credit?

By Marc Pearlman

A common misconception among taxpayers is that a tax credit is the same as a tax deduction. This is not only false, it's a potentially expensive case of mistaken identity.

Simply stated, tax deductions reduce taxable income. A lower taxable income translates into fewer taxes paid by the taxpayer. The IRS has created two methods for utilizing tax deductions. A taxpayer can either take a standard deduction or take itemized deductions. There are a few factors to consider when deciding which route to go.

The easier of the two routes is the standard deduction, which the IRS makes available to the majority of taxpayers. However, familiarize yourself with eligibility requirements before arbitrarily going this route. For example, a married individual filing a separate return whose spouse itemizes deductions must also itemize.

The standard deduction amounts are set forth by the IRS and are adjusted yearly based on filing status and inflation. While taking the standard deduction is the easier of the two methods to calculate, the standard deduction may not save you the most money. This is when the itemized deductions may come into play. If itemizing your deductions will save you more money, then it is prudent to itemize and is worth the extra work.

Itemizing deductions often benefit taxpayers who paid interest or taxes on a home, had big out-of-pocket medical expenses, made large charitable donations or had sizable unreimbursed employee business expenses.

A tax credit, on the other hand, is a dollar-for-dollar reduction of taxes owed. Tax credits are valuable and you don't want to miss out on using one. For example, if you owed $3,000 in taxes after all deductions and then applied a $3,000 tax credit, your tax liability would be a big fat zero. Even better, some tax credits are refundable. This means if you are eligible and claim one, you can get the rest of it in the form of a tax refund even after your tax liability has been reduced to zero!

Below are four refundable tax credits you will want to be aware of when you are filing your 2011 federal income tax return.

1. The Earned Income Tax Credit

The Earned Income Tax Credit applies is you earned less than $49,078 in 2011 from wages, self-employment or farming. There are a few factors which determine the amount of the credit. These factors include your income, age and the number of qualifying children claimed on your return. This is a nice credit and can be up to $5,751. Workers without children also may be eligible.

2. The Child and Dependent Care Credit

The Child and Dependent Care Credit is for expenses paid for the care of your qualifying children under the age of 13. It is also used for a disabled spouse or dependent while you work or look for work.

3. The Child Tax Credit

The Child Tax Credit is for people who have a qualifying child. The maximum credit is $1,000 for each qualifying child. Remember, you can claim this credit in addition to the Child and Dependent Care Credit. My wife and I have three kids so I know this is one credit that can really help families with multiple qualifying children.

4. The Retirement Savings Contributions Credit

The Retirement Savings Contributions Credit, also sometimes referred to as the Saver's Credit, is designed to help workers with low to moderate income save for retirement. You may be eligible for this credit if your income is below a certain limit and you contribute to an IRA or qualifying retirement plan, such as a 401(k) plan. Like the Child Tax Credit, this credit is available in addition to any other tax savings that apply.

This article is for information purposes only and should not be construed as tax advice.