Exemptions, Deductions and Credits

When you enter a tax office and speak with a preparer, you will hear the terms “exemption”, “deduction” and/or “credit” – no matter how involved your tax return.   

What, exactly, are they referring to?  Are these terms interchangeable?  What do you have to do to get an exemption, a deduction or a credit?  And, most importantly of all, how does it affect what you owe (or get back from) Uncle Sam?  Here’s the “down and dirty” on each of these terms. 

First, remember that exemptions and deductions reduce your gross income or adjusted gross income before you compute the tax.  Credits are a dollar-for-dollar reduction of the actual tax liability.  If your tax liability is reduced to zero, some credits are actually refundable!

Exemptions – The most common exemption is the personal exemption for the taxpayer, spouse or children, or other dependents (this amount is indexed for inflation each year).  Personal exemptions are claimed on page 1, but subtracted from income at the top of page 2, of Form 1040. When your income exceeds the amounts listed below (based on income and filing status), the personal exemption begins to phase out:

• $117,300 for married persons filing separately
• $156,400 for single individuals
• $195,500 for heads of household, and 
• $234,600 for married persons filing jointly or qualifying widow(er)s.

You can lose no more than 2/3 of the dollar amount of your exemptions. In other words, each exemption cannot be reduced to less than $1,133.

Examples:        

Jim is head of household, makes $35,000 a year and claims an exemption for himself.  His personal exemption is $3,400. 

John is single, makes $100,000 a year and claims an exemption for himself.  His personal exemption is $3,400. 

Joe is married, makes $500,000 a year and claims an exemption for himself.  His personal exemption is $1,133. 

Deductions – Deductions are either “above the line” or “below the line” – the line being the last line on page one of the 1040 – your Adjusted Gross Income(AGI).  Some of the most common above the line deductions:  educator’s expense, student loan, student tuition and fees, alimony paid and Health Savings Account deductions.  These deductions reduce your AGI.  Below the line deductions reduce your taxable income: standard deductions (based on your filing status) or itemized deductions. 

Examples:

Sharon is a teacher who makes $30,000 per year.  As a teacher, she is qualified to take the Educator’s Expense deduction since she spent her own money on classroom supplies.  This deduction reduces her gross income by $250, to an AGI of $29,750. 

Sharon files head of household, and is eligible to take the standard deduction of $7,850 on page two of Form 1040.  This deduction reduces her taxable income to $21,900. 

Credits  - Credits can reduce your tax liability dollar-for-dollar, or be added to your refund.  Those credits that reduce your taxable income include child and dependent care expenses, child tax credit and residential energy credit; they are non-refundable credits.  Those that can be added to your refund include additional child tax credit and earned income credit.   

Example: 

Sharon’s taxable income is $21,900.  Her tax on this income is $1,709.  Because she has a qualifying child, she is eligible for a Child Tax Credit of $1,000. Her new tax is $709.  Sharon made payments of $3,000 through Federal Income Tax withholdings, and $514 in Earned Income Credit.  Sharon’s refund is $2,805. 

Still confused?  Leave us a note in the comments section at the end of this article.  We will do our best to clear up any lingering questions.

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