What’s The Difference Between Tax Deductions, Tax Credits and Tax Exemptions?
Tax Deductions, Credits and Exemptions: What’s the Difference Between These Tax Benefits?
When it comes to preparing your tax return, there are different kind of tax benefits that may apply to you: deductions, credits, and exemptions. People tend to use these terms interchangeably when describing how they do their taxes, but they have incredibly different meanings as well as impact on your tax return.
In the absolute simplest terms, a deduction reduces your taxable income while a credit is a dollar-for-dollar reduction of your bill (making credits far more beneficial than deductions in most cases.) An exemption is a universal number determined by the government every year that applies to many people as well as their dependents. However, each tax benefit can be explained with more depth.
Your filing status is what determines your eligibility for many tax benefits as well as the proper dollar amounts you need to reference. It is often based on marital status and/or household composition. For instance, if you are unmarried and have no dependents then your status is most likely Single. Married taxpayers can file jointly or separate (MFJ or MFS status) but having dependents often has no bearing on your filing status unless you are an unmarried person with eligible dependents for Head of Household status.
Deductions reduce your taxable income and are considered prior to your tax bill (and subsequently, tax credits) being calculated, as well as before exemptions are factored in. There are two types of deductions: deductions that can be taken above-the-line and below-the-line. Below-the-line deductions are split up into standard and itemized deductions. Standard deductions are determined by filing status as well as age (if 65 or older) and blindness. Meeting one or both of these conditions will equate to a larger standard deduction. Itemized deductions, on the other hand, are claimed if you have certain expenses such as mortgage interest and real estate taxes, medical bills, state income tax, gifts to charity, and other deductible items.
Above-the-line deductions, also called adjustments, can be found on the front page of a 1040 tax return and claimed by anyone who qualifies for them regardless of whether they take the standard or itemized deduction. This makes them more beneficial than below-the-line deductions because most people claim the standard deduction. Additionally, many itemized deductions as well as tax credits will hinge on a figure called adjusted gross income (AGI) which is your total reported income less your adjustments. Adjustments include things like moving expenses for a job, traditional IRA contributions, 50% of self-employment tax, and student loan interest. Because these adjustments help reduce AGI, they compound the benefits computed benefits later in your tax return.
After the standard or itemized deduction has been elected then deducted from your AGI, personal and dependent exemptions are computed next. Exemptions are tied to your filing status as well as how many eligible dependents you have. Most people take their own exemption as well as their spouse’s if married filing jointly (even if the spouse has no income) but the only people who cannot take their own exemption are those who can be claimed as someone else’s dependent, such as a college student who is earning money from work study and part-time jobs but meets the age and income requirements to be claimed by their parents as a dependent.
The personal exemption is a pre-determined amount set by the government every year. For the 2016 tax year, the personal exemption amount is $4,050 per person. A single taxpayer with no dependents would claim $4,050 in exemptions while a married couple with one child would claim $12,150 in exemptions.
Higher-income taxpayers are subject to a phase-out range for personal exemptions. IRS Publication 501 details the thresholds where phase-out range begins (for single taxpayers, $259,400 is the AGI level where the phase-out begins while it is $311,300 for a married couple filing jointly) followed by calculations that determine what point you have a $0 exemption. However, most people can typically claim the full personal exemption amount for themselves and their dependents.
After deductions and exemptions are taken, the tax liability is computed. If you are eligible for any tax credits, they are taken directly off of the tax liability which makes them the most beneficial of all tax breaks.
Credits are split into two categories: refundable and non-refundable. Non-refundable credits are applied to your tax liability and in the event the credit exceeds your tax liability, you will lose any additional money and simply owe zero in income taxes. There are some exceptions such as the Child Tax Credit for certain income brackets where there is a refundable portion of the credit, but it is otherwise “use it or lose it”.
Refundable credits are more beneficial than non-refundable credits because they can be refunded to you regardless of how much your tax liability is. The Earned Income Tax Credit for instance, as well as the refund of excess Social Security taxes if you are higher-income and start a new job and additional FICA gets withheld by accident, will be refunded to you regardless of your tax liability. Tax deductions are still incredibly valuable, but credits are even better and refundable credits are the most beneficial tax break of all.
Rue & Associates is here for all of your tax preparation needs, no matter how many tax benefits you qualify for and which types. We strive to make tax time less stressful by staying up-to-date on all the latest tax law changes so that you can be sure you will receive all benefits you are entitled to. Please give us a call today to speak to one of our friendly and professional tax law experts.