What’s the Difference Between Tax Exemptions and Tax Deductions?

Two years ago, our tax preparer suggested we take advantage of tax breaks like IRAs and home ownership. We then looked at our options and started working on our IRAs. Buying a house just for a tax break wasn’t what we wanted, so we paid down our debt and saved some money on the side for our upcoming town house purchase.

We did, however, realize that we needed to be more informed when it comes to taxes, and to (legally) maximize any tax breaks we can get. If you’ve read much about taxes, you’ll no doubt have seen the terms “exemption” and “deduction.” Today, I’m going to talk a bit about what these terms mean, and why they matter.

Exemptions vs. deductions

First off, exemptions and reductions both reduce your taxable income, which is a good thing. Exemptions are specified amounts by which you reduce your taxable income — just for being you! For 2009, federal income tax exemptions (either personal or for dependents) are $3,650 each.

There are adjusted gross income (AGI) limits beyond which the exemptions are phased out. The specific limits vary depending on your filing status.

• Single: $166,800
• Married (Filing Separately): $125,000
• Head of Household: $208,500
• Married (Filing Jointly): $250,000

Income tax deductions, on the other hand, are actual expenses that you’ve paid during the tax year that you can claim against your taxable income. Some examples of expenses you can deduct are alimony, moving expenses, and charitable contributions.

Personal exemptions vs. dependent exemptions

As you may know, you can claim one exemption for yourself as long as you’re not claimed a dependent on someone else’s taxes. You can also claim an exemption for your spouse if you file a joint return.

Beyond this, you can claim an exemption for each person that you claim as a dependent — provided you meet the requirements. If you claim a child as a dependent for your taxes, then the relationship must pass a five part test:

• Age: Are they 18 or under? If they are a full time student, that increases to 23 or under.
• Relationship: They should be a member of your family such as your child, stepchild, sibling, or decedent of any of them.
• Support: The child cannot provide more than half of their own support.
• Residency: The child being claimed must have lived with your for the majority of the year, with some exceptions.
• Special test: Only one person can claim a qualifying child. You can’t divide the tax exemption. The IRS has rules to determine who gets the exemption if the parents can’t agree.

Besides claiming a child, there is an exemption for a qualifying relative. There are 4 tests that must be met to claim this exemption:

• Not a qualifying child: This simply means they can’t fall under the qualifying child rules if you are to claim the relative exemption.
• Member of household/family member: This is a residency based test to determine if they’re a member of your household. In some cases, such as relationships created by marriage, the relative may not have to live with you to qualify. Check with IRS Publication 501 for more details.
• Gross Income: The qualifying relative must have less than $3,500 in gross income during the tax year.
• Support: You have to provide more than half their total support. There are special rules if multiple people contribute more than 50% of the total support in aggregate, but no one individual does so.

Be honest with your answers and you’ll be able to claim the exemptions to which you’re legally entitled.

Standard vs. itemized deductions

When it comes to income tax deductions, you can either claim the so-called standard deduction, or you can itemize your deductions. You cannot do both. Obviously, you should choose the option that results in a lower tax bill.

In short, you should claim the standard deduction if you don’t have much in the way of itemized deductions. The standard deductions for most people are:

• Single/Married (Filing Separately): $5,700
• Head of Household: $8,350
• Married (Filing Jointly): $11,400

You can qualify for a higher standard deduction if you’re 65 or older or blind. Check IRS Publication 501 for more details. If you’re considering itemizing your deductions, take a look at Topic 500 – Itemized Deductions on the IRS website. It covers possible deductions for the following expenses and more:

• Medical and dental expenses
• State and local taxes
• Home mortgage points
• Interest expense
• Charitable contributions
• Business expenses
• Educational expenses

Closing thoughts

I’ve done my best to ensure that the above listed amounts are current (for tax year 2009), but you should always double-check to make sure that you’re working with valid information. You should also check with the IRS itself, or a qualified tax professional, to get answers relevant to your specific circumstances.

With that said, I’m curious to see how many of you file your own taxes. We did it ourselves last year, and we’re plan on doing it again this upcoming tax season.