The Importance of IRS Terminology in Saving Money on Taxes
Exemptions, deductions and tax credits are different items that impact how much tax is owed:
- Credits reduce 100% of the amount of tax owed.
- Deductions reduce the amount of income, so that less tax is paid based on the tax rate.
- Exemptions are multiplied by a fixed amount to arrive at a number to reduce income, similar to a deduction.
How Tax Exemptions Work
Each individual is given one exemption for themselves, and one additional for each dependent. A taxpayer with a spouse and three dependent children would receive five exemptions.
There is only on exemption per person per year. An exemption cannot be claimed on a return if they are claimed as an exemption on any other person’s return. This includes the exemption for the taxpayer.
If another person is dependent on the taxpayer, for instance, an adult parent, the taxpayer would be able to claim an additional exemption for that person. If the adult parent has enough income to file a separate return, they cannot be claimed as an exemption on both their own and another’s return.
The number of exemptions is multiplied by the exemption amount ($3,500 in tax year 2008) and deducted from Adjusted Gross Income (AGI).
Exemptions can be different than withholding allowances, which are given to employers on Form W-4 during the year.
Itemized or Standard Deductions
AGI is also reduced by deductions. Taxpayers can use the greater of itemized deductions or the Standard Deduction. Examples of itemized deductions are home mortgage interest, state taxes and charitable contributions.
The Difference between Credits and Deductions
The key difference is in the amount of tax that each reduces. A tax credit reduces income tax liability by 100% of the credit, a deduction only reduces taxes by the amount of the deduction times the tax rate.
In a simplified example, for a taxpayer in 2008 with an adjusted gross income of $50,000 and a tax rate of 28%; a tax deduction of $5,000 will reduce taxable income to $45,000, resulting in a tax liability of $12,600.
In the same situation, with a tax deduction of $0, but a tax credit of $5,000, the tax liability would be $9,000 ($14,000-$5,000).
It is clear that when it comes to reducing taxes, a credit is much preferable to a deduction.
Examples of Tax Credits
Since there is a greater reduction in taxes associated with credits, they are more limited, but in the recent tax bill, credits are available for first time home buyers and improving a home’s energy efficiency.
Tax credits continuing from prior years include credits for child care and educational expenses. Details are available from the Internal Revenue Service.
Lowering the tax bill or increasing the refund requires knowledge of the IRS rules.