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The Difference Between Exemptions, Deductions, and Credits

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

In short, the difference between deductions, exemptions, and credits is that deductions and exemptions both reduce your taxable income, while credits reduce your tax.

Exemptions

For 2017, you were entitled to an exemption of $4,050 for yourself, one for your spouse, and one for each of your dependents.

EXAMPLE: Kevin and Jennifer are married, with a combined income of $80,000 in 2017. They have four children, whom they claim as dependents. They will be allowed six exemptions of $4,050 each. As a result, their 2017 taxable income will be reduced by $24,300.

For 2018 and future years, however, exemptions will no longer exist. (This is one of the big changes from the new tax law.)

Deductions

Deductions generally arise from your expenses. For example, a deduction is allowed for interest paid on student loans.

EXAMPLE: Carlos is in the 12% tax bracket. Over the course of the year, he paid $2,000 in student loan interest. This $2,000 decrease in his taxable income will save him $240 in taxes ($2,000 x 12%).

Types of Deductions

Deductions are often grouped into two categories:

  1. “Above the line” deductions, and
  2. “Below the line” deductions (also referred to as “itemized” deductions).

Every year, you can claim all of the above the line deductions for which you qualify, as well as:

  1. The itemized deductions for which you qualify, or
  2. A fixed amount known as the “standard deduction.” (In 2018, the standard deduction is $12,000 for a single taxpayer or $24,000 for a married couple filing jointly.)

Here’s how it looks mathematically:

Total income (sum of all your income)
Above the line deductions
=  Adjusted gross income ← “The Line”
Standard deduction or itemized deductions
=  Taxable income

A key point here is that above the line deductions are always valuable, whereas itemized deductions are only valuable if and to the extent that they (in total) exceed your standard deduction amount. That is, if your itemized deductions in a given year are less than the standard deduction you’ll simply claim the standard deduction in that year rather than using your itemized deductions. And your itemized deductions will therefore not provide you with any tax savings.

Some common above the line deductions include contributions to a traditional IRA, contributions to a Health Savings Account (HSA), and interest paid on student loans.

Common itemized deductions include charitable contributions, the interest on a home mortgage, and medical/dental expenses.

EXAMPLE: Eddie is a single taxpayer. During the year he contributes $3,000 to a traditional IRA, and he makes a charitable contribution of $1,000 to the Red Cross. He has no other deductions, and his income (before deductions) is $50,000.

The IRA contribution is an above the line deduction, and the charitable donation is an itemized deduction. Using our equation from above, we get this:

$50,000 total Income
$3,000 Above the line deductions
= $47,000 Adjusted Gross Income ← “the line”
$12,000 Standard deduction
= $35,000 Taxable Income

Important observations:

  1. Eddie’s itemized deductions ($1,000) are less in total than his standard deduction ($12,000). As such, Eddie’s charitable contribution doesn’t provide him with any tax benefit, because he’ll elect to use his standard deduction instead of his itemized deductions.
  2. Eddie’s above the line deduction provides a tax benefit even though he’s using the standard deduction.

Again, itemized/below the line deductions only help when they add up to an amount greater than your standard deduction. Above the line deductions, on the other hand, are always beneficial.

Credits

Unlike deductions, credits reduce your taxes directly, dollar for dollar. After determining the total amount of tax you owe, you then subtract the dollar value of the credits for which you are eligible. This makes credits particularly valuable.

Credits arise from a number of things. Most often, they are the result of the taxpayer doing something that Congress has decided is beneficial for the community. For example, you are allowed a credit of up to $2,500 for paying “qualified education expenses” for one of your dependents. If you meet the requirements to claim the maximum credit, your tax (not taxable income) will be reduced by $2,500.

“Pre-Tax Money”

You’ll often hear the term “pre-tax money,” generally used in a context along the lines of, “You can pay for [something] with pre-tax money.” This means one of two things:

  1. The item is deductible, or
  2. The item can be paid for automatically in the form of a payroll deduction.

The reason these situations are sometimes referred to as “pre-tax” is that you get to spend this money before the government takes its cut. This makes it more cost-effective for you.

You may, from time to time, run across people who are under the impression that something is free simply because it’s deductible or because they were allowed to spend pre-tax money on it. This is a severe misunderstanding. Being able to spend pre-tax money on something is more akin to getting a discount on it than it is to getting the item for free.

Simple Summary

  • Deductions reduce your taxable income. Aside from the standard deduction, deductions generally arise from your expenses.
  • Each year, you can use either your standard deduction or the sum of all your itemized (below the line) deductions.
  • Above the line deductions are particularly valuable because you can use them regardless of whether you use your standard deduction or itemized deductions.
  • Credits, unlike deductions, reduce your tax directly (as opposed to reducing your taxable income). Therefore, a credit is more valuable than a deduction of the same amount.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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