When it comes to saving money on US taxes, you have a handful of options. For most investors, the easiest paths lie in investing in a 401k plan or other tax deferred retirement plan, and investing in a tax efficient manner so that you aren’t paying unnecessary tax on capital gains, dividends and interest. Yet there are still other ways to save on taxes, namely with tax credits.

Most taxpayers get confused when the topic of tax credits and tax deductions come up. In fact, many mistakenly assume that a tax credit is the same as a tax deduction. The reality is that the two are very different and one is much more powerful at saving you money than the other.

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So which one is better? Should you try to get every tax credit possible? Or are you better off using every tax deduction available? In this post, I’ll clear all this up so you can save the most money possible on your taxes.

Tax Credits vs. Tax Deductions

Before we can talk about which one of these tax savings you should focus on, we first have to understand how each one works.

  • Tax Credits: This is a dollar-for-dollar write off on your taxes. For example, if you are able to take a $1,000 credit, you reduce your income by $1,000.
  • Tax Deductions: This is a write off on your taxes that is proportional to your tax bracket. For example, if there is a $500 tax deduction and you are in the 25% tax bracket, you can write off $125.
  • Let’s look at each of these in another example. Let’s say you are single and earn $50,000 annually. This puts you into the 25% tax bracket. You have $2,500 worth of student loan interest you paid during the year.

    As it stands, student loan interest is a tax deduction. Since you paid $2,500 and are in the 25% tax bracket, you can claim a deduction of $625. This reduces your taxable income from $50,000 down to $49, 375.

    Now, let’s assume that student loan interest were a tax credit instead. In this case, the entire $2,500 would be written off as a credit. This reduces your taxable income from $50,000 down to $47,500.

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