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.
For 2014, you are entitled to an exemption of $3,950 for yourself, one for your spouse, and one for each of your dependents.
[Note: These exemptions are reduced if your total income, minus your above the line deductions (which we’ll discuss shortly) exceeds a certain threshold—for 2014, $254,200, or $305,050 if married filing jointly.]
EXAMPLE: Kevin and Jennifer are married, with a combined income of $80,000. They have four children, whom they claim as dependents. They will be allowed six exemptions of $3,950 each. As a result, their taxable income will be reduced by $23,700.
Deductions generally arise from your expenses. For example, a deduction is allowed for interest paid on student loans.
EXAMPLE: Carlos is in the 25% tax bracket. Over the course of the year, he paid $1,600 in student loan interest. This $1,600 decrease in his taxable income will save him $400 in taxes ($1,600 x 25%).
Itemized Deductions or Standard Deduction?
Several deductions (such as charitable contributions or the interest on your home mortgage) fall into the category known as “itemized” deductions. Sometimes, these are known (as we’ll discuss momentarily) as “below the line” deductions. Every year, you have the choice to use either:
- The sum of all of your itemized deductions, or
- The standard deduction ($6,200 for a single taxpayer in 2013, or $12,400 for a married couple filing jointly).
For the most part, this decision is pretty easy. Simply add up all of your itemized deductions, and compare the total to the standard deduction you would be allowed. Then simply take whichever option allows you a larger deduction.
Above the Line vs. Below the Line Deductions
If a deduction does not fall into the category of itemized, or “below the line,” it must be what is known as an “above the line” deduction. Above the line deductions are helpful because you can claim them regardless of whether you choose to use the standard deduction or your itemized deductions.
Some common above the line deductions include contributions to a traditional IRA, interest paid on student loans, or contributions to a Health Savings Account (HSA).
In contrast to above the line deductions, which are always useful, below the line/itemized deductions are only valuable if and to the extent that they (in total) exceed your standard deduction amount. 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
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 a below the line (a.k.a. itemized) deduction.
Using our equation from above, we get this:
$50,000 Gross Income
— $3,000 Above the line deductions
= $47,000 Adjusted Gross Income ← “the line”
— $3,950 Exemption
— $6,200 Standard deduction
= $36,850 Taxable Income
- Eddie’s itemized deductions ($1,000) are less in total than his standard deduction ($6,200). 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.
- 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.
Unlike deductions and exemptions, 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.
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:
- The item is deductible, or
- 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 will, from time to time, run across people who seem to be 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.
- You are entitled to one exemption for yourself, one for your spouse, and one for each of your dependents. In 2014, each exemption reduces your taxable income by $3,950.
- Deductions arise from your expenses, and they reduce your taxable income.
- 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 and exemptions, reduce your tax directly (as opposed to reducing your taxable income). Therefore, a credit is more valuable than a deduction of the same amount.