Credits and Deductions

When managing your taxes, it's important to understand the difference between a credit and a deduction. Credits are dollar-for-dollar “bonuses” that you get from the IRS. In other words, a credit reduces the amount of tax you owe by the amount of the credit (a $500 credit reduces your tax bill by $500). Credits are usually much better for you than deductions.

Deductions reduce the amount of income that you get taxed on. A $500 deduction does not reduce your tax bill by $500. Instead, it reduces your taxable income by $500. You pay less in taxes, but you don't give a dollar-for-dollar reduction. If you pay taxes at 25 percent, a $500 deduction might save you $125 in taxes (25 percent of $500).

Education Benefits

In your twenties and thirties, you should particularly keep your eye out for education benefits. You may be finishing college or pursuing an advanced degree. The best way to make sure that you take advantage of these benefits properly is to talk with an accountant or tax preparer. Each benefit has its own set of rules and restrictions.

Hope Scholarship

If you are in your first two years of postsecondary education, look into the Hope Scholarship. This program offers a tax credit of up to $1,650 (in 2007). It is one of the most powerful education benefits, as you get a dollar-for-dollar credit on the first $1,100 of qualified expenses. You'll have to qualify with certain income, enrollment, and other characteristics. The credit cannot exceed the amount you owe in taxes (in other words, you can't get a refund of $1,650 if you don't owe any taxes), but it can easily bring your tax liability closer to zero.

Lifetime Learning Credit

If you can't qualify for the Hope Scholarship, investigate the Lifetime Learning Credit. This allows you to earn a credit even if you are in graduate school, and for some continuing education expenses related to your job. The maximum credit is $2,000, but you only get credited 20 percent against your education expenses (so you have to spend $10,000 to get the entire credit).

Other Benefits

There are a variety of other tax benefits that you might qualify for if you are enrolled in any type of educational program. Get creative, and you can save a few bucks in taxes. For example, employer-provided educational assistance can be extremely powerful. Find out if your employer will help you pay for school — this can be much more useful than a small raise. If you have a family business, the business can pay for somebody's schooling. It can take up to a $5,250 deduction, which the recipient receives tax-free.

Another possibility is a deduction for tuition and fees. This deduction may not be around forever, but it allows people at higher income levels to get a deduction. Finally, you may be able to take a deduction against your state income taxes (if your state has a tax) by making contributions to a 529 college savings plan. In many cases, you can take the money back out shortly after making the contribution (within a few months or less).

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  4. Credits and Deductions
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