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


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It's that time once again, but don't despair. Here's a chance to test your tax IQ -- and sharpen your tax-slashing skills.

Sorry. We feel obliged to inform you that tax time is right around the corner.

We know you’ve just packed away the tree ornaments, but those W-2s and 1099s will begin arriving soon. To test your knowledge on tax basics, take the quiz below. Then, if you bomb — no shame! — just read on to raise your tax IQ.

You miss the April 15 filing deadline. The government is going to fine you big-time, right?

El Nariz / Shutterstock.comEl Nariz / Shutterstock.com

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 the day after taxes are due. The failure-to-pay penalty isn’t quite as hefty, coming in at 0.5 percent of your unpaid taxes. You can read more about the penalties on this IRS tax tip sheet.

(By the way, the deadline for filing 2016 tax returns is Tuesday, April 18, this year, rather than the traditional April 15 date. For more details, see this IRS page.)

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 IRS 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?

Rawpixel.com / Shutterstock.comRawpixel.com / Shutterstock.com

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.

True or false: Someone making millions of dollars can have a lower tax rate than someone earning $100,000

karen roach / Shutterstock.comkaren roach / Shutterstock.com

Oh, you knew this one was true, right?

The internet is full of articles about how the super rich manage to lower their effective tax rate to less than what more average Americans might pay.

While every situation is different, a major reason for the lower tax rate among the wealthy could be how they earn their money. Rather than going to a 9-to-5 job and pulling down a salary, the top income earners may bring in their money from the sale of stocks and other assets. Money earned from most of those sources, known as capital gains, is taxed at a rate of no more than 20 percent, assuming the asset is held for at least one year. (Short-term capital gains, made on assets held for less than a year, are subject to higher rates.) This IRS publication explains more.

You need an accountant to get your taxes done, right?

Robert Kneschke / Shutterstock.comRobert Kneschke / Shutterstock.com

Nah, you’ll probably be fine on your own.

Today’s tax preparation software makes it easy to complete your own tax return even if you’re self-employed or have cashed in some investments. A couple of good options are TaxAct and TurboTax, but you have plenty of options from which to choose. If your income is below $64,000, you can even use some programs to file your taxes for free. Just head to the IRS Free File site for links to participating software providers.

Of course, tax professionals have their place. If you own a business or have a complicated tax situation, using a pro can be money well spent.

If you’re not sure whether you need a tax preparer, remember that many online tax prep sites will let you prepare your return at no cost and charge you only when you file. You can try these sites first, and if you find yourself confused or the numbers don’t seem to add up, you can easily shift to an offline preparer without paying a dime to the website.

Another great option, if you really want to get on top of your tax game: Check out our online course, “Mastering Taxes: Slash Your Taxes and Have Fun Doing It.”

Did you know all the answers? Share your results in the comments below or on our Facebook page.

Stacy Johnson

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