Pop Quiz: Is It Better to Have a Tax Credit or a Tax Deduction?

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It’s almost tax time (yes, really). Take our pop quiz to see if you know the best ways to dodge a hefty bill from the taxman this year.

At the risk of ruining the holiday season, we feel an obligation to inform you that tax time is right around the corner.

Yes, shortly after you pack away the tinsel and tree trimmings, those W-2s and 1099s will begin arriving. To see how well the average citizen understands tax time basics, Money Talks News finance expert Stacy Johnson went to Times Square to quiz the people there.

In the video below, the man on the street totally dominated this pop quiz with a perfect score. Can you do the same? After watching the clip, scroll down for more information about each answer.

You miss the April 15 filing deadline. The government is going to fine you beaucoup bucks, right?

Maybe not.

The government does assess both failure-to-file and failure-to-pay penalties, and those aren’t cheap. The failure-to-file penalty is 5 percent of your unpaid taxes each month, and it begins accruing April 16. The failure-to-pay penalty isn’t quite so hefty, coming in at 0.5 percent of your unpaid taxes. You can read more about the penalties on this IRS tax tip sheet.

However, the failure-to-file penalty applies only to tax returns on which you owe money. If you’re due a refund, there’s no penalty for late filing. However, the IRS says you don’t want to wait too long, or you could lose your refund entirely. Here’s what the agency says on its website.

There is no penalty for failure to file if you are due a refund. But, if you wait to file a return or otherwise claim a refund, you risk losing a refund altogether. An original return claiming a refund must be filed within three years of its due date for a refund to be allowed in most instances.

Which is better: A tax credit or a tax deduction?

A tax credit wins every time.

The reason is simple. A tax deduction lowers your taxable income, while a tax credit lowers your tax bill dollar for dollar.

Here’s an example, with rounded numbers for simplicity. Let’s say you have a $50,000 income and fall into the 25 percent tax bracket. A $1,000 tax deduction reduces your taxable income to $49,000, which would drop your tax bill by $250. However, if you were to have a $1,000 tax credit, your tax bill would be reduced by $1,000. You come out $750 ahead with a tax credit.

Tax credits come in two types: refundable and nonrefundable. Let’s say you owe $500 in taxes and have a $1,000 nonrefundable tax credit. In that case, your $500 tax bill would be wiped out and that would be the end of the story. But if you have a $1,000 refundable tax credit, your tax bill would be wiped out, plus you would get $500 back from the government.

If you want to learn more about what credits and deductions are available, this IRS page is the place for you.

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