How do tax deductions, tax exemptions and tax credits work?

When you file your federal income tax return each year, you will use tax deductions, tax exemptions and tax credits to help you determine how much you owe in taxes. You will compare the amount you owe to the amount you already paid in taxes throughout the year, to figure out:

• How much you owe in total taxes for that year

• Whether you paid more than you owe and need a refund

• Whether you paid less than you owe and have to make a payment

When filing taxes and determining how much you owe, you will have to know:

• What are Adjusted Gross Income (AGI) and taxable income?

• What is your total AGI for the current tax year?

• What deductions and exemptions should you subtract from your AGI to get your taxable income for the current tax year?

• What tax credits will you receive from the IRS?

• How much did you pay in taxes and do you owe more or will you receive a refund?

This article will help you learn the basics of deductions, exemptions and credits. It can help when reading through this to have Internal Revenue Service (IRS) Form 1040 in front of you. Download a copy at:

• IRS Form 1040: www.irs.gov/pub/irs-pdf/f1040.pdf

What are adjusted gross income and taxable income?

The most important number on your tax form is your Adjusted Gross Income (AGI). Your AGI is calculated by subtracting above-the-line deductions from your total income. Above-the-line deduction is the common name for about a dozen tax adjustments that the Internal Revenue Service (IRS) allows you take for various things.

Some of the most common above-the-line deductions are:

• Contributions to Individual Retirement Arrangements (IRAs)

• Interest paid on student loans

• Some educator expenses

• Tuition and fees

These above-the-line deductions are set by the IRS each year and most appear directly on your tax form 1040. A few also require that you file a special form to take them. You can view these tax adjustments and required forms on the IRS website:

• IRS Tax Topics: Adjustments to Income: www.irs.gov/taxtopics/tc450.html

After you subtract these above-the-line deductions from your total income, the figure you get is your AGI. Lowering your AGI is your first step to reducing your overall tax bill, especially because if your AGI is too high, you won’t qualify for many helpful tax benefits.

Taxable income is different from AGI — it is the next step in calculating how much you will actually owe in tax. To calculate taxable income, you subtract additional tax exemptions and deductions — either a standard deduction or itemized deductions — from your AGI. This gives you the amount of income that will be subject to tax that year. The less your taxable income, the less you’ll owe the IRS.

Your taxable income is equal to your AGI minus tax deductions and tax exemptions

You use your taxable income to look up what your tax rates will be for that tax year. If you have certain types of income, such as dividends or capital gains from stocks or mutual funds, you’ll also run through a special worksheet because some income is taxed at different rates.

Some people in very special circumstances may also have to pay an alternative minimum tax (AMT), which uses a separate set of rules to calculate taxable income after allowed deductions. AMT can apply to people who pay a lot of state income or property tax or have a lot of personal exemptions (for example, if you have a lot of kids). Each year Congress passes a temporary measure to make sure most people don’t pay AMT, but if it ever doesn’t pass, don’t be surprised if you find yourself with an extra surcharge on your tax return if you have any of these AMT items.

How to calculate your tax deductions, tax exemptions and tax credits

Tax deductions, tax exemptions and tax credits are different, but you use them to calculate the amount of taxes you will be required to pay for that year.

Deductions

There are two forms of deductions: standard deductions and itemized deductions. When you file taxes, you will take one or the other, but not both. You subtract deductions from your adjusted gross income to get your taxable income.

Standard deductions

A standard deduction is a set amount that everyone can take. The standard deduction is an dollar amount based on your filing status — whether you file as single, married filing jointly, married filing separately, head of household — with a small addition if you are blind or over age 65. The amount allowed for this deduction adjusts each year.

Itemized deductions

Itemized deductions are specific expenses you paid throughout the year that you can subtract individually from your AGI. Itemizing your deductions is more complicated than taking a standard deduction because you need documentation and forms to account for any expenses you intend to deduct. If your itemized deduction comes out to more than your standard deduction, it is worth the effort. Taking itemized deductions will reduce the amount of your income that is subject to tax.

We recommend working with a financial or tax professional if you’re itemizing deductions to make sure you are filing correctly. It requires that you file a form called an IRS Schedule A, which is a way to track all your various itemized deductions.

• IRS Form Schedule A: www.irs.gov/instructions/i1040sca/index.html

To receive the tax benefit from your deductions, you must list or itemize all those expenses on your tax return, using the Schedule A. Common types of itemized deductions are charitable donations, property tax payments, mortgage interest, big medical expenses, state and local income taxes, unreimbursed business expenses and more.

If you'll be itemizing, here are some of the documents and figures you will want to keep track of throughout the year:

• Charitable donation receipts

If you made charitable donations to qualified 501(c)(3) nonprofit organizations, save your receipts. If you made donations less than $250, you can use a bank statement, a returned check or a letter from the nonprofit as a statement of your donation.

• Property tax payments and mortgage interest payments

If you paid any property taxes, track your payments. Also, in January or early in the New Year, look for form 1098 to arrive by mail or email, which will document any interest you paid on a mortgage.

• Medical bills for large expenses

If you had large medical expenses, save all your receipts and also any documentation of the health insurance premiums you paid.

• State taxes paid

If you paid state taxes the past year, the total amount paid is deductible. Don’t forget any state income tax you paid when you filed the previous year’s tax returns.

How to choose between standard and itemized deductions

If you’re not sure which kind of deduction to take, tally up your itemized deductions and compare it to the current year standard deduction. If your itemized deductions don’t add up to more than your standard deduction, you don’t need to itemize. Just take the standard deduction.

If you think you spend enough to itemize — if you own property that is high value and have high taxes, for example — track your expenses during the year and try for the itemized deduction. It may amount to much more in tax savings.

Exemptions

Exemptions are similar to deductions because you also subtract them from your AGI in order to determine your taxable income. That’s why it’s important to make sure you’re correctly taking your exemptions, as well as your deductions.

Unlike deductions, exemptions are based on the number of people in your household who file taxes together. Each year, you are legally entitled to one personal exemption for yourself and one for each person who qualifies as a dependent. A dependent is simply someone who relies on you for the majority of his or her financial support. A dependent can only be claimed once. So if you are married filing separately and have one child, only one spouse can claim that child. Just like the standard deduction, these amounts adjust annually.

You list exemptions on your Form 1040 when filing taxes. You also list them on the W-4 form you file when starting a full-time job. The form W-4 tells your employer how much tax to withhold from your paychecks every pay cycle based on your exemptions — called your withholding. You might end up listing a different number of exemptions on your 1040 and your W-4, though the two forms unfortunately use the same word.

Ideally, the exemptions you take on your W-4 will match up with the number you list on your 1040. Unfortunately, that isn’t always the case especially if you have a second income in your household or itemize your deductions. Just keep in mind that exemption has a slightly different meaning on your W-4 and 1040. And if your marital status changes or you have a child, update your W-4 with your employer to make sure they are withholding taxes correctly.

• See also: Withholding and estimated taxes

Credits

A tax credit is different from tax deductions and tax exemptions. You don’t subtract them from your AGI to get your taxable income. It’s better than that — it’s a reduction in your tax bill.

After you know your taxable income, you use that figure to look up how much you will owe in taxes that year using the IRS tax rates. Once you have that figure, you subtract any credits you qualify for from that amount. Your tax minus your credits is the total amount of your tax bill from that year.

Rather than being something you deduct from your taxable income, a credit directly reduces the amount of tax that the IRS will charge you. This works out better than a deduction — a quick example shows why. If you’re in the 15% tax bracket, a $1,000 deduction from your taxable income saves you $150 in tax. But a $1,000 credit saves you $1,000 in tax.

Credits change year by year and can cover a range of things from education and dependent care to credits for energy-efficient home improvements. This is an area of taxes that you have to keep up on, to see what special credits you might qualify for. For current year credits, visit the IRS website:

• IRS Tax Topics: Tax credits: www.irs.gov/taxtopics/tc600.html

You also get credits for any taxes you’ve already paid — including income tax your employer withholds from your paycheck. If you are self-employed and pay quarterly estimated taxes, the IRS will credit you for those payments and remove them from what you owe.

Words to know

Unsure about something you read? Many of the financial terms you came across in this article are defined in our financial glossary. A-Z Glossary

Links we like

Here are a couple online features you might find useful:

• IRS Federal Tax Return: Form 1040: www.irs.gov/pub/irs-pdf/f1040.pdf

• IRS Tax Topics: Itemized Deductions: www.irs.gov/taxtopics/tc500.html

• IRS Tax Topics: Standard Deductions: www.irs.gov/taxtopics/tc551.html

• Kiplinger: The most overlooked tax deductions: www.kiplinger.com/features/archives/the-mostoverlooked-tax-deductions.html