When tax season arrives, everyone wants to know the magic trick to lower their tax burden. But terms like credits, exemptions, and deductions often have clouded meanings.
Are they the same thing, or does each have a distinct purpose? Do I as a taxpayer qualify for all three?
Before preparing your tax returns, know the difference between tax exemptions, deductions, and credits. Exemptions and deductions reduce your taxable income. Credits reduce the amount of tax you owe. All three are important items that save you money. Let’s examine how each can benefit you.
Exemptions are portions of your personal or family income that are ‘exempt’ from taxation. The Internal Revenue Code allows taxpayers to claim exemptions that reduce their taxable income. Both personal and dependent exemptions lower the amount of your taxable income. That ultimately reduces the amount of total tax you owe for the year.
For tax purposes, all dependents receive exemptions, including you and your spouse. To the Internal Revenue Service (IRS), these are the people for whom you are financially responsible. A higher number of exemptions reduces your taxable income. In most cases, dependents must be:
- A family member or qualified relative
- Age 18 or below (except for full-time college students under age 24)
- Cannot provide over half of their economic support.
You can reduce your taxable income by multiplying the dollar value of a personal exemption, which is a predetermined amount, by the number of your dependents. For example, in 2017, the personal exemption is $4,050. It’s the same amount for your spouse and each dependent as well. These exemptions are reduced if your adjusted gross income (AGI) exceeds $261,500 as a single filer or 313,800 if you’re married and file a joint return.
Example: Josh and Kristen are married with a combined income of $90,000. They have three children whom they claim as dependents. That means they can claim five exemptions of $4,050 each. That reduces their taxable income by $20,250.
Deductions stem from your expenses, and there are two types. Both “above-the-line” and “below-the-line” deductions are claimed on IRS Form 1040, U.S. Individual Income Tax Return, even though they impact your income differently.
Above-the-line deductions reduce your adjusted gross income (AGI). Below-the-line deductions are subtracted from your AGI to determine your taxable income. The “line” referred to is your AGI. There are significant differences between their benefit to you.
Deductions above-the-line are initially more advantageous than below-the-line because they reduce your AGI. Typically, a lower AGI means you have fewer restrictions when it comes to taking advantage of other tax benefits, like below-the-line deductions and various tax credits.
Some examples of above-the-line deductions include:
- Educator expenses
- Job-related moving expenses
- Penalties for early withdrawal of CDs and savings accounts
- Qualified tuition and fees
- Self-employed deductions for health insurance premiums
- Half the Self-Employment Tax
- Traditional retirement plan contributions
- Student loan Interest
- Traditional IRA contributions
Standard or itemized deductions are considered below-the-line. These type of deductions are limited to the amount of the actual deduction. A $3,000 below-the-line itemized deduction reduces your taxable income by $3,000. If you choose to take the standard deduction, your AGI is reduced by the standard deduction amount designated for the tax year. In 2017, the standard deduction for single filers is $6,350 and for married couples filing jointly, it’s $12,700.
Example: Josh and Kristen contribute $5,000 to a traditional IRA and give $3,400 to their local church. Neither one of them participates in a retirement plan through their work. The IRA contribution is an above-the-line deduction, and the church gifts are a below-the-line deduction. Remember, in the first example above, Josh and Kristen’s combined income before any reductions is $90,000.
The calculations for Josh and Kristen’s taxable income looks like this:
While Josh and Kristen’s church donation is an itemized deduction, the amount ($3,400) is far less than the standard deduction ($12,700). So, their charitable contribution doesn’t provide any tax benefit. They can deduct more by using the standard deduction.
Additionally, Josh and Kristen’s IRA contributions are an above-the-line deduction and provide a tax benefit even though they use the standard deduction.
Remember, below-the-line deductions are only a benefit when their combined total is higher than your standard deduction. Above-the-line deductions are always helpful.
Credits differ from deductions and exemptions because credits reduce your tax bill directly. After calculating your total taxes, you can subtract any credits for which you qualify. Some credits address social concerns for taxpayers, like The Child Tax Credit, and others can influence behavior, like education credits that help with the costs of continuing your education.
There are numerous credits available for a wide range of causes, and all reduce your tax liability dollar for dollar. That means a $1,000 tax credit reduces your tax bill by $1,000. Reviewing all the options may be time-consuming, but could also prove to be profitable.
Some major tax credits are:
- Foreign tax credit
- Credit for child and dependent care expenses
- Education credits
- Retirement savings contributions credit (Saver’s Credit)
- Child tax credit
- Residential energy credits
Example: Let’s examine how a credit can reduce Josh and Kristen’s tax liability. Remember, after exemptions and deductions, their taxable income was $52,050. In 2017, income levels between $18,650 and $75,900 owe a tax of $1,865 plus 15 percent of the remaining income over $18,650. Those tax rates are for married adults filing a joint return.
Based on the 2017 tax brackets, Josh and Kristen owe $6,895 in taxes. However, since they have three qualifying children as dependents, they are also eligible for the Child Tax Credit. When that credit is subtracted from their tax liability, their total tax is reduced to $3,860. Use this calculator to determine which your 2017 tax rate.
Exemptions, deductions, and credits make a significant impact on the amount of income tax you owe. Understanding the differences and benefits of each is important to gaining the total benefit.