Everyone wants to get money back at tax time – even me, and I’m a tax guy.

Part of the problem – a hurdle to get over – is getting a handle on how taxes work. We’re going to start getting over that hurdle in this three part article series.

In this first instalment, we’ll look at the meaning of deduction and credit. Then in the second instalment we’ll look at some non-refundable tax credits, and we’ll hit the jackpot in the third instalment when we see what’s available in refundable tax credits.

When we’re finished with tax credits, I’ll send out another series to help us all with deductions. But for now, let’s look at what those terms mean – how they impact our tax bill.

The first number we all deal with when it comes to taxes is our gross income. That’s the total of all the money we earned, won in the lottery, and inherited from that long lost uncle in Poughkeepsie.

Once we know how much gross income came in, we get to figure out how much of it we have to pay taxes on. Yep, you got it – taxable income.

To determine the taxes owed, we are using a single person. Let’s call her Mary. This is important because marital status changes which tax table you use and what tax rate is applied.

To get from gross income to taxable income, we use deductions and exemptions. (We’ll get to credits in a minute.) The government let’s us take deductions and exemptions from our gross income so we don’t have to pay quite so much tax. Three of the most common deductions are mortgage interest, retirement plan contributions and charitable contributions. Exemptions come with breathing – just by being alive (no dead jokes, please).

Here’s a quick example:

Gross Income $75,000

Deductions

Mortgage Interest $7,000

401K $1,000

State and Local Taxes Withheld $1,500

Charity $1,000 ($10,500)

$ 64,500

Personal Exemption ($ 3,500)

Taxable Income $ 61,000

You brought in $75,000, but you only have to pay taxes on $61,000. Cool.

At this point, Mary, a single person with no dependents or tax credits, and has a tax bill of $10,319.

To Your Credit

Credits are things you spend money on that the government says are “good.” It’s sort of the same as doing extra assignments in school so you get extra credits from the teacher.

In the case of the government and taxes, you get credits for dependent children, being a first-time homebuyer, or even for suffering a big drop in income.

The thing about a credit is that it’s applied against how much you owe rather than how much you earned. See the difference? Deductions and exemptions lower your income so you can pay less tax. Credits actually help you get that tax amount paid.

Let’s look at Mary again, except now she is a head of household (HOH) with three dependents (that was pretty quick, huh?) and still has $75,000 in income.

She gets a $1,000 credit for each child and because Mary just had her third child, she gets a “bonus” $300 Stimulus credit. She bought her first house with a tree-swing and white picket fence, and for that, she gets a $7,500 credit (first time home-buyer credit). Now we have $10,800 in tax credits.

Mary, our HOH with three dependent children, now has a tax bill of $7,694. Fortunately, the credits make a major difference.

Mary goes from owing $7,694 to getting a $10,646 refund. Not bad for getting a new house and having children.

You can see where good planning – making the most of deductions and credits –pays off handsomely at this point.

Of course, without any planning – you wouldn’t have made retirement contributions, supported local charities, had another baby or bought that new house. And then you’d be stuck having to pay that miserly, tightwad of an uncle another $7,694 of your hard-earned money. It’s really even higher because removing deductions – retirement contributions and charitable donations – increases taxable income.

So now we understand two things:

1. We know the difference between a deduction and a credit, and

2. We know you’d better make good use of both if you want any money back from Uncle Sam.

Stick around for the next two articles. The first one takes us through the jungle of non-refundable tax credits. They’re good, they’re useful, but they’re not the best.

The best is saved, naturally, for last. The third article will show you the pot of gold to be found in refundable tax credits. Not only do they lower the tax you owe – they can put money back in your pocket.