During tax season, it is a good idea to understand how these three categories — taxes, exemptions, and credits — work. And how they will not work for you. Luckily it isn’t the most difficult thing in the world to study up on. In fact, it is pretty simple. But, like a lot of things in life, we underestimate them, and they sneak up and bite us in the butt. We all had that class that was the easiest one on our schedule, so we didn’t try, didn’t show up, didn’t do the homework, etc. Yeah, you remember what happened with that class, don’t you? We failed that class … These three rascals are easy to understand, but if you don’t put in the leg work to acquire said understanding, then you won’t be able to take advantage of them as much as possible.
Exemptions
Exemptions reduce your taxable income proportional to your individual tax bracket. And no, you cannot pick and choose tax brackets. You can find out where you fall when it comes to tax brackets here. Exemptions are relationship-based. This means that they concern people, and namely, what relationship you have to people. They are used to determine whether someone is or is not a dependent, for instance, but they have no other financial basis to them.
So. The more exemptions you have, the less taxable income that you have (operative word here is taxable, i.e. more exemptions does not translate to less income). Depending on which exemptions you claim, you are telling the IRS which people you are responsible for (and all the rest, who can go to hell. Just kidding).
* This tax season, you can reduce your taxable income by $4,050 per person. The Tax Cuts and Jobs Act of 2017 (TCJA) has done away with personal exemptions for tax years 2018-2025, so this is the last year you will be able to claim them for a while. You, your spouse and all your dependents receive exemptions.
Dependents: If they are not full-time students, they generally must be 18 years old or younger. In addition, they must be a member of your family, or a qualified relative. They can only be supplying up to half of their own economic support (usually). Your pets don’t qualify as dependents in the eyes of the IRS (probably because they’re soulless. The IRS … not your dog. Although…). Exemptions slowly decrease once income reaches a certain threshold. For 2017 taxes, the threshold begins at $156,900 in Adjusted Gross Income (AGI) if married filing separately, $261,500 if single and $313,800 if married filing jointly.You can consult IRS Publication 501 for further qualifications and disqualifications.
* If somebody claims you as a dependent, you sadly are excluded from claiming a personal exemption for yourself.
Deductions
Deductions impact your expenses. But the degree, and way, in which deductions will impact your expenses will depend upon two different criteria: A) Whether your expenses are above-the-line or below-the-line and B) whether your expenses are scaled relative to your income.
While both above-the-line and below-the-line deductions will affect the amount of taxable income you have, they do so to a varying degree. Plus, the amount of above-the-line deductions might affect the amount of below-the-line deductions you have as well.
The AGI Line: This line refers to your adjusted gross income. After you have reported all your income that is subject to taxation to the IRS, you can then reduce that number you have arrived at by adding in “above-the-line deductions.” After that, what you are left with is your AGI figure. The amount of AGI you report to the IRS will directly determine how many other deductions they will allow you to take — below-the-line (sometimes called itemized) deductions — as well as which tax credits you are eligible for. Usually, the lower your Adjusted Gross Income is, the less harsh the IRS will be about limiting your access to certain tax benefits.
Deductions can either be standardized deductions — a fixed amount the IRS agrees to deduct -— or itemized deductions — based on a specific list compiled by you. The standard deduction, like the word standard implies, is not individually based, nor does it have anything to do with you and your personal expenses. But it is a decent estimate and saves you the hassle of itemizing. The standard deduction for tax season 2017 is $6,350 for those single or married but filing separately
Note: The standard deduction has been doubled from $12,000 to $24,000 from tax season 2018 onward. This obviously makes itemizing more unattractive for many. Additionally, post-2017 tax season, quite a few itemized deductions have been eliminated and the limits on some have been changed.
Credits
Credits are behavior-oriented. What this means is the IRS is trying to control our brains. Just kidding! But they are trying to impact our behavior (try not to think of Orwell’s 1984, if you can help it). Credits are most often applied to areas such as education and residential energy in order to motivate populations to take certain steps. They also are sometimes created to address societal concerns such as the Child Tax Credit — which essentially help parents keep their children safe and healthy — or the adoption credits that incentivize adoption, or at least make it less fiscally straining to adopt. Major credits have a separate line on Form 1040. Unearthing miscellaneous credits can be time-consuming, but it could prove to be time well-spent.
Note: From 2018 onward, the Child Tax Credit will be doubled to $2,000 for each qualifying child from 2018 to 2025, and a new $500 tax credit will be added for non-child dependents. This change is being made to try and help offset the damage from eliminating the personal exemption (which is part of the new tax bill). Also, be alert about your opportunities in the credit arena if you are a student!
Takeaway
All three of these categories are helpful in saving dough, but a more-or-less accurate hierarchy, just to keep in mind when it comes to potential savings, is
- Credit
- Above-the-line deductions
- Exemptions
- Below-the-line deductions.
Of course, every one of these four will lead to tax savings — so be sure to claim all that you are entitled to, regardless of their size. And don’t be afraid to consult a qualified tax professional because finding all the little things you qualify for can be deceptively tricky.
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