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Tax Deductions vs. Tax Credits vs. Income Tax Exemptions: What You Need to Know

Tax Deductions vs. Tax Credits vs. Income Tax Exemptions: What You Need to Know

With an all new federal tax bill on the horizon, you may be one of the millions of people wondering how it is going to affect your tax bracket, standard deduction and itemized deductions. The good news is, this year, you can breathe easy, as most of the changes aren’t going to go into effect until the 2018 tax season. 

Right now, you should spend your time focused on the tax credits and deductions you are allowed today, and make sure you are prepared for next year’s taxes too. 

How Do Income Tax Exemptions, Deductions and Credits Work? 

While credits, deductions and exemptions can all help you save o your taxes, they all work differently. Understanding each one is imperative to making sure you have the lowest tax liability possible. 

Income Tax Exemptions 

A tax exemption is determined by the number of dependents you are financially responsible for. This can include you, your spouse, your kids and an elderly parent. If you don’t make more than $384,000 (for individuals) and $436,300 (for couples) you can receive $4,050 off of your total taxable income for every dependent claimed. According to the new tax code, the personal exemptions will be eliminated; however, they can still be used for 2017.

Tax Credits 

A tax credit is something you have likely heard of before. It will cut your taxes dollar for dollar. For example, if you receive a $100 tax credit, then your tax bill is going to be reduced by $100. Even if you don’t owe any taxes, you may still be eligible for tax credits. 

There are two primary types of tax credits you can receive:

  • Refundable: In this situation, if you have a refundable tax credit of $500, and owe the IRS $200, you will receive a check for $300.
  • Nonrefundable: However, if you have a nonrefundable tax credit that is worth $750, but owe $250 in taxes, you aren’t going to receive the difference. 

Tax Deductions 

A tax deduction is what will reduce your taxable income and possibly reduce, or even eliminate, your tax liability. You may have heard that the standard deduction is going to double under the new tax bill, or if you should itemize your taxes. You may even be confused about what steps to take next. 

However, before you try to handle your taxes, you need to understand the different types of deductions available, so you can figure out what the right option for you is. 

  • Standard deduction: This is really a “tax freebie,” if you don’t itemize your deductions. Based on your filing status, the standard deduction will reduce your adjusted gross income by a certain amount and reduce the total amount of taxes you are required to pay. 

Besides the standard deduction, there are two additional ways that you can reduce your tax liability:

  • Above-the-line adjustments: These can be used for adjusting your gross income. An additional bonus is that you can claim these (if you qualify) regardless of if you choose to itemize your deductions or claim the standard deduction. Examples of these include moving expenses, HSA premiums, tuition, certain retirement plan contributions, educator expenses and student loan interest. 
  • Itemized tax deductions: Provides the possibility for you to receive a larger tax break than what is offered by the standard deduction if you have the required eligible expenses. Examples include charitable donations, unreimbursed employer expenses, medical expenses, natural disaster losses, real estate tax, local sales tax, state income tax and mortgage interest. 

If you are unsure of what you are entitled to, it is best to ask a professional as they will be able to provide assistance. 

The Bottom Line 

As you can see, there are significant differences in income tax exemptions, credits and deductions. Understanding what these are can help you understand what you can potentially save when you file your taxes. Keep in mind, if you aren’t sure about what you need to do, or how to save the most money possible on your tax return, then it may be a good idea to work with a professional accountant. They can ensure you receive the tax exemptions, credits and deductions you deserve and that you either receive a tax refund or have the lowest tax liability possible. 


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