Posted by Abundant Wealth Planning LLC

Tax Deductions VS Tax Credits VS Tax Exemptions

Tax Deductions VS Tax Credits VS Tax Exemptions


With the tax season just rounded up, everyone wants to know the magic trick to reduce their tax burden. But terms like credits, exemptions, and deductions often have a nebulous meaning when it comes to an exact definition of tax exemption.

Are they the same, or do they each have a different purpose? As a taxpayer, can I benefit from all three?

When preparing the tax return, the first question that comes to my mind is, how many tax cuts am I qualified to claim? Before preparing your tax returns, you should understand the tax exemption examples as they will help you understand the difference between tax exemptions, deductions, and credits. Exemptions and deductions reduce taxable income. Credits reduce the amount of taxes owed. All three are important for saving money. Let's see how each can benefit you.

 

Tax Exemptions

As defined by tax exemptions and deductions, exemptions are parts of your personal or family income that are "exempt" from tax. The Internal Revenue Code allows taxpayers to claim exemptions that reduce their taxable income. Personal and salary exemptions reduce the amount of taxable income. This ultimately reduces the total amount of tax owed for that year.

For tax purposes, all dependents have exemptions, including you and your spouse. For the Internal Revenue Service (IRS), these are the people for whom you are financially responsible. More exemptions reduce taxable income. In most cases, dependents should be:

  • 18 years or less (excluding full-time students under 24)

  • A family member or a qualified relative

  • They cannot provide more than half of their financial support.

You can reduce your taxable income by multiplying the dollar amount of a personal exemption, which is predetermined by the number of people you claim as dependent. For example, in 2017, the personal exemption was $4,050. It is the same amount for your spouse and also for each dependent. As part of the tax exemption definition, these exemptions are reduced if the Adjusted Gross Income (AGI) exceeds $261,500 as a single taxpayer or 313,800 if you are married and file a joint tax return.

Example: John and Jane are married and have a combined income of $90,000. They have three children who they claim to be dependents. This means they can claim five exemptions of $4,050 each. This reduces taxable income by $20,250.

 

Tax Deduction

According to the definition of tax exemption, deductions come from your expenses, and there are two types. The "above-the-line" and "below-the-line" deductions are required on the IRS Form 1040, United States Income Tax Return, although they affect income differently.

Above the line deductions reduce Adjusted Gross Income (AGI). While below the line deductions are deducted from the AGI to determine taxable income. The "line" mentioned is your AGI. There are significant differences between its benefits for you.

Above-the-line deductions are initially more beneficial than below-the-line deductions because they reduce your AGI. In general, lower adjusted gross income means you have fewer restrictions for taking advantage of other tax benefits, such as below-the-line deductions and more tax credits.

What are the exemption deductions? Here are some examples of above the line standard deductions:

  • Alimony

  • Contributions to a traditional retirement plan

  • Deductions for the self-employed for health insurance premiums

  • Educator Expenses 

  • Half of the self-employment tax

  • Qualified tuition and fees

  • Sanctions for early withdrawal of CDs and savings accounts

  • Student loan interest 

  • Traditional IRA contributions

  • Work-related moving expenses

Standard or itemized deductions are taken into account below the line. These types of tax deductions and exemptions are limited to the amount of the actual deduction. For the tax exemption definition, the itemized deduction of $3,000 below the line reduces your taxable income by $3,000. If you choose to benefit from the standard deduction, your adjusted gross income will be reduced by the standard deduction amount designated for the year. In 2017, the standard deduction for single taxpayers was $6,350, and for couples filing jointly $12,700.


Example: John and Jane donate $5,000 to a Traditional IRA and donate $3,400 to their local church. None of them participated in a retirement plan through their work. The IRA contribution is an above-the-line deduction, and church donations are considered as a below-the-line deduction. Remember, in the first example above, John and Jane's combined income before any discount is $90,000.

Although John and Jane's donation to the church is an itemized deduction, the amount ($3,400) is much lower than the standard deduction ($12,700). Therefore, their charitable contribution does not provide tax benefits. They can deduct more using the standard deduction.

Additionally, John and Jane's IRA contributions are above-the-line deductions and provide a tax benefit, although they use the standard deduction.

Please note that below the line deductions are only a benefit when the combined total is greater than your standard deduction according to the definition of tax exemption. Above the line, deductions are always useful.

 

What is a tax credit, and how does it work? How to get a tax credit?

Tax credits differ from deductions and exemptions in that they directly reduce your tax. After calculating the total tax, you can deduct the credits to which you are entitled. Some credits address the social concerns of taxpayers, such as the child tax credit, and others can influence behavior, such as education credits that help cover the costs of further education.

There are many credits available for a wide variety of causes, reducing tax debt dollar for dollar. This means that a $1,000 tax credit reduces the tax bill by $1,000. Going through all the options can take time, but it can be worth it.

Some important tax credits are:

  • Child care credit and dependent care expenses 

  • Child tax credit

  • Education credits

  • Foreign tax credit

  • Residential energy credits

  • Saver's credit


Example: Let's see how tax credit can reduce John and Jane's tax debt. Remember that 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% of residual income over $18,650. As per the definition of tax exemption, these tax rates apply to married adults who file together.

Calculation of total taxes due according to the definition of tax exemption: Based on the 2017 tax cuts, John and Jane have debts of $6,895. However, since they have three eligible dependent children, they are also eligible for the child tax credit. When this credit is deducted from your tax debt, the total tax is reduced to $3,860.

 

In conclusion, Exemptions, standard deductions, and credits significantly impact the amount of income tax payable. Understanding the differences and advantages of each is important to reap the full benefits.


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