Tax Credit vs. Deduction

I could never figure out the difference between a tax credit and a tax deduction. I would appreciate some clarification on this subject. Thanks.

Good question -- especially this time of year. A tax credit lowers your tax bill dollar for dollar. A deduction shaves money off your taxable income, so the value depends on your tax bracket. If you're in the 25% bracket, a $1,000 deduction lowers your tax bill by $250. But a $1,000 credit lowers the bill by the full $1,000, no matter in which bracket you are.

This difference becomes important, for example, if you pay college tuition and you're choosing between taking the Hope tax credit or the tuition deduction. The Hope credit can lower your tax bill by up to $1,650 per child in the first two years of college (the Lifetime Learning credit can reduce your taxes by up to $2,000 after that). To qualify for those tax credits for 2006, though, your income must be less than $110,000 if married filing jointly, or $55,000 for single filers.

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If you can't qualify for this credit, you still may be able to take the tuition deduction, which lets you deduct up to $4,000 in qualified college expenses you paid during the year. If you are in the 25% tax bracket, then this deduction can lower your tax bill by $1,000.

If you qualify for either the Hope credit or the tuition deduction, the Hope credit is more valuable (you can't take both tax breaks in the same year). But if you earn too much to take the Hope, then the tuition deduction can still shave some money off your tax bill. To qualify for the full $4,000 deduction, your adjusted gross income must be $130,000 or less in 2006 if married filing jointly ($65,000 or less if single). You can deduct up to $2,000 in tuition and fees if your joint income was $160,000 or less ($80,000 or less if single). There is no deduction if you earn more than that. You don't need to itemize to qualify.

See Don't Miss the Tuition Deduction for special rules about how to claim the tuition deduction for your 2006 taxes because the tax law was renewed so late in the year that it wasn't included on the tax forms.

For more information about the rules for both tax breaks for paying college tuition, see IRS Publication 970 Tax Benefits for Education.

For more help with your taxes, visit the Kiplinger Tax Center.

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As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.