Exemptions and Credits

The one thing that makes taxes a little bit less painful are exemptions, deductions and credits, which are taken from your gross income.

Personal exemptions
Taxpayers can deduct a set amount for themselves and each qualifying dependent. This amount changes from year to year to adjust for inflation. In 2001, it was $2,900. If you had a baby in December of 2001, you could have claimed the child for the entire year. To claim parents or other relatives, you must pay over 50% of their total expenses. When divorced or separated couples disagree on who will claim the children from their marriage, tax law allows the parent who provides more than half of the child's support to claim the exemption. Generally, tax rules consider the parent who has custody of the child for the greater part of the year as the one who provided more than one-half of the support. The custodial parent can release the exemption to the non-custodial parent by signing a written declaration.

Deductions and credits
A tax deduction allows you to subtract from your taxable income, reducing the amount that you are taxed on. A credit is applied at the end, and is subtracted directly from your tax liability.

For instance, let's say that you are in the 23.5% total tax bracket, earn $27,000 per year, and get a $500 deduction for some reason. Before your deduction, you would pay $6,345 in taxes. To take a deduction, you reduce your taxable income of $27,000 by $500, bringing it to $26,500. Now you find out what 23.5% of your new taxable income is, which is $6,227.50. You saved $117.50 by claiming that deduction. But say that you have a $500 credit instead of a deduction. To figure that, you take your tax liability based on $27,000 at your tax bracket, but now subtract $500 from your $6,345 tax liability. Your new tax bill is for $5,845. A $500 tax deduction only saved you $117.50, whereas a $500 tax credit saved you the full $500. So the important difference is that a deduction is taken before you calculate your tax liability and a credit is taken after you calculate your tax liability.

Some tax credits are refundable and some are not. If a tax credit is refundable, it means that you get the full amount of the credit, even if it exceeds what you owe in taxes. For instance, say that you figure out you owe $350 in taxes, but you are able to claim a $500 credit. If the credit is refundable, you get a tax refund of $150 in the mail. If the credit is not refundable, the credit reduces your tax liability to zero, but you don't get anything back.

Standard and Itemized Deductions
Do you take the standard deduction, or do you itemize using Schedule A? The standard deduction varies according to your filing status.

When taxpayers itemize, they deduct amounts paid for state and local taxes, home mortgage interest, charitable contributions, and other expenses. Some of the deductions that have limitations are medical expenses, casualty and theft losses, and employee business expenses. For most taxpayers, itemizing is not possible without the write-off from home mortgage interest and property taxes.

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