It is easy to lump exemptions, deductions and credits into the same basket of tax-saving mechanisms, but they are distinctly different. Here are the simplified differences:
What They Reduce – Deductions and exemptions both reduce your taxable income, and credits reduce your overall tax bill. With reference to Form 1040, exemptions and deductions all take effect before line 43 (your taxable income), and credits are applied after line 44 (the tax you pay on that taxable income).
Exemptions and deductions reduce your taxes proportionally to your tax bracket, but credits reduce your taxes dollar-for-dollar regardless of your tax bracket. In other words, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 on your taxes, but a $1,000 tax credit saves you $1,000 on your taxes.
Their Basis – Exemptions are only concerned with people and the relationship you have with them; aside from determining whether or not someone is a dependent, they have no financial basis. Deductions are related directly to expenses you incurred over the course of the tax year. Credits are generally incentives aimed at influencing behavior.
View important tax dates to know:
Important tax dates to know
What are exemptions, deductions and credits?
January 15, 2016: Those who are self-employed or have fourth-quarter income that requires payment for quarterly estimated taxes must have them postmarked by this date
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April 18, 2016: Individual tax returns are due for the 2015 tax year
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April 18, 2016: Requests for an extension on filling out your taxes must be filed by this date
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April 18, 2016: Those who are self-employed or have first-quarter income that requires payment for quarterly estimated taxes must have them postmarked by this date
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April 18, 2016: This date is also the deadline to make a contribution to an IRA account for 2015
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June 15, 2016: Those who are self-employed or have second-quarter income that requires payment for quarterly estimated taxes must have them postmarked by this date
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September 15, 2016: Those who are self-employed or have second-quarter income that requires payment for quarterly estimated taxes must have them postmarked by this date
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October 17, 2016: 2015 tax returns that received an extension are due by this date
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October 17, 2016: Today is the last chance to recharacterize a traditional IRA that was converted to a Roth IRA during 2015
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January 15, 2017: Those who are self-employed or have fourth-quarter income that requires payment for quarterly estimated taxes must have them postmarked by this date
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Let's look at the three categories in more detail:
1. Exemptions – A higher number of exemptions reduces your taxable income – essentially this says to the IRS, "these are the number of people I am responsible for." You, your spouse, and all your dependents receive exemptions.
Generally, dependents must be age 18 or younger (except for full-time students), a member of your family or a qualified relative, and must provide less than half of their own economic support. Unfortunately, your pets, while dependent on you, do not qualify as legal dependents in the eyes of the IRS. See IRS Publication 501 for details on who qualifies as a dependent.
You can reduce your taxable income by a set amount of money multiplied by the number of dependents. Exemption amounts are scaled back above certain income levels. For 2015 taxes, the threshold is $154,950 in Adjusted Gross Income (AGI) if married filing separately.
You cannot claim a personal exemption for yourself if someone else claims you as a dependent. Use the I.R.S. Interactive Tax Assistant to determine if you can claim someone as a dependent.
2. Deductions – Deductions are related to your expenses, but their impact varies based on two criteria – whether they are "above-the-line" or "below-the-line" expenses, and whether they are scaled relative to your income.
The other distinction in deductions is whether they are itemized – a list of individual deductions you can take – or a standard deduction that you can apply. The standard deduction is based on your filing status and has nothing to do with your actual expenses.
"Above-the-line" deductions mean they are used in figuring your AGI, before you have to decide whether to itemize or take a standard deduction. This means you can take these deductions whether you itemize or not. "Below-the line" deductions are itemized, and some can only be taken once the expenses exceed a certain percentage of your AGI. This makes above-the-line deductions doubly useful.
3. Credits – Credits are generally incentives aimed at one of two goals: to influence behavior, such as education credits and residential energy credits; or to address a societal concern, such as the child tax credit or adoption credits. Major credits have a separate line on Form 1040. Rooting out miscellaneous credits and the requisite IRS forms can be time-consuming but could prove to be time well-spent.
Some savings, like education costs, can be redeemed as either a credit or a deduction, depending on qualifications for each. Therefore, when trying to decide which is best, remember this hierarchy from generally most effective to least – credit, above-the-line deductions, exemptions, and below-the-line deductions. However, all of these are tax savings – so take all to which you are entitled, regardless of their size. If you need help in determining how to best utilize the exemptions, deductions and credits that may be available to you, seek out a qualified tax professional.
RELATED: 10 of the strangest ways states tax you
10 Strangest Ways That States Tax You (or Don't)
What are exemptions, deductions and credits?
To preserve the uniqueness of their island paradise, Hawaii since 2004 has had an "Exceptional Tree" tax allowance. Landowners can deduct up to $3,000 from their income for expenses such as pruning and fertilization for any tree designated as rare, big, old or a combination thereof. That's per tree. Top-bracket earners taxed at the state's highest rate (11 percent) would save $330 via the deduction. The work must be done by a certified arborist, and the deduction can be claimed only every third year. Hawaii has had a list of "Exceptional Trees" since 1975, and there are now estimated to be more than a thousand thus designated.
Maine legislators tax anyone who deals in their official state fruit-blueberries, at the rate of 1.5 cents per pound. The resulting revenues-more than $1.6 million to state coffers in the fiscal year that ended in June 2013-are used to promote the crop and agricultural research.
The state also taxes harvesters and processors of hard-shell clams (known in the state as mahogany quahogs) at $1.25 a bushel, but state revenues for that are much lower.
Alabama is the last in the union to tax a deck of cards as if it were a "vice," like alcohol and tobacco. Taxing decks of cards, associated with gambling, was once fairly common, but most states have since set up separate control boards to regulate liquor and tobacco, and have let the cards slide.
But in Alabama, you'll still pay a 10 cent sales tax on any pack of cards you purchase. Retailers also have to pay $2 to the state each year for the privilege of selling playing cards.
Virginia levies a 50-cent excise tax on every lamb or sheep sold in the state. Both the Maine and Virginia taxes are examples of checkoff programs that collect taxes from an industry to fund promotional campaigns for the products. National commodity checkoff programs, authorized by the U.S. Department of Agriculture, have brought you campaigns such as "Beef: It's What's for Dinner" and "Got Milk?" But the Virginia program is extremely modest by comparison, having collected only $9,000 in fiscal year 2013. The funds go to the Virginia Sheep Industry Board, which spends them largely on predator control.
In 2013, in part to meet federal pollution-control mandates, Maryland legislators enacted fees on property owners in Baltimore and nine other Maryland counties, aimed at curbing storm water runoff. The fees were meant to fund programs to improve the water quality of the Chesapeake Bay, the largest marine estuary in the U.S. Sounds simple enough, but the way Maryland legislators wrote the law has led to an angry backlash in some corners against this so-called “rain tax.” One way localities calculate the tax is by measuring how much of a landowner’s tract is "impervious" to precipitation seeping into the ground. So the more you've developed it with buildings, driveways, tennis courts and the like, the less it will absorb and the more you pay. That's how the tax is being implemented (through aerial and satellite photos) in Montgomery County, a heavily developed suburb of Washington, and many landowners are up in arms. New Maryland Gov. Larry Hogan, a Republican, campaigned against this tax in his winning 2014 campaign and has introduced legislation to repeal it, though it’s not clear that will fly with Democratic state legislators. Money still needs to be raised to satisfy the federal pollution mandates, but the methods may change.
Kansas is among a bevy of jurisdictions that allows sale of lower-alcohol beer (the term of art is “cereal malt beverage”) in convenience and grocery stores. But Kansas also taxes “3.2” beer differently -- and there lies the rub. At a liquor store, all products, including, say, a conventional six-pack of Budweiser (with 5 percent alcohol by volume), are taxed at a special rate of 8 percent. At the convenience store down the street, however, ordinary sales tax is levied on the lower-alcohol, cereal malt beverage bottle of Bud. That often ends up being more than the 8 percent alcohol tax. In Pomona, Kansas, for example, the effective rate on the weaker beer would be 9.7 percent. Go figure.
When it comes to taxation, the rule is generally the stronger the booze, the higher the tax (that's why Kansas's beer tax scheme is an anomaly). California follows that curve, but at 100 proof, you better be ready to pay through the nose. Distilled spirits are taxed at $3.30 a gallon if below 100 proof, or 50 percent alcohol. Go over that, like with Bacardi 151, and the tax doubles to $6.60. Maryland also notes the 100 proof point, but it only adds 1.5 cents per proof, per gallon to the relatively modest liquor tax of $1.50 per gallon, taking the Bacardi 151 to $2.27 per gallon.
Entertainment venues pay a business tax to Nevada ranging from 5 percent to 10 percent on admissions fees (and food, drink and merchandise sales) whenever there’s live entertainment going on. There are exemptions, however, including this one, for businesses that provide "instrumental or vocal music, which may or may not be supplemented with commentary by the musicians, in a restaurant, lounge or similar area if such music does not routinely rise to the volume that interferes with casual conversation and if such music would not generally cause patrons to watch as well as listen." So your piano player can play “Feelings” softly and even crack a few jokes, tax-free, for your business. Just make sure they're not funny enough to attract attention.
Want to own a plush or fuel-thirsty ride? That’ll cost you extra in New Jersey. Cars that cost $45,000 or more or have a combined EPA fuel-mileage average of 19 or below pay an additional 0.4 percent on top of New Jersey’s 7 percent sales tax.
In New Mexico, making it to 100 years has a payoff beyond the chance that Willard Scott will wish you a happy birthday: You don’t have to pay state income tax anymore. If you’ve been physically present in the state for at least six months and a resident of the state on the last day of the year, and you’re not someone’s dependent, you’re eligible. You’ll still need to file, and there are some complications if you’re married and your spouse doesn’t qualify.
Selling your kid's old bicycle is not likely to cause any tax consequences, but when you sell crafts, vintage or specialty items on websites like Etsy, you must report and pay taxes on your net income. You will also likely need to pay self-employment tax on your profits, and in some locations, you may also be responsible for charging and collecting sales tax.
If you use vehicles in your small business, how and when you deduct for the business use of those vehicles can have significant tax implications. It pays to learn the nuances of mileage deductions, buying versus leasing and depreciation of vehicles. Special rules for business vehicles can deliver healthy tax savings.
Congress has passed the largest piece of tax reform legislation in more than three decades. The bill will affect the taxes of most taxpayers, but one key point to keep in mind is that for most people, the bill won't affect your taxes for 2017 (the one you file in 2018).
Every April, many taxpayers wait until the last minute to file their federal income tax returns. Despite this tendency, there are many reasons to file your taxes early. If you will receive a refund, you may want to submit your return as quickly as possible. Additionally, there are benefits to filing early for those taxpayers who have a balance due.