Difference between tax deductions, adjustments, credits & exemptions

Last Revised on December 25, 2010

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Tax season is almost here already and many people who are too much familiar with filing taxes may be wondering about the most commonly used terminologies and the differences among them. Some of them are easy to guess and understand, whereas others are difficult to know what they really mean. We will try to simply them here

What’s the difference between tax deductions, adjustments, exemption and credits?

All of them help reduce your taxes, but they all do it differently. Here is how:

Exemptions are tax breaks granted by the government. We saw a lot of tax breaks in the recent years and especially this year 2010 due to tough economy. When you file tax return, you are entitled to exemption to yourself and your dependents who could be children under your care and older adults living at home with you.

Deductions are however little bit different, even though it yields tax breaks too. Deductions come from your expenditures, money you spent on items that government considers are very helpful and thus deserve tax cuts. Most popular tax deductions are student loans and payments. When you fill out tax return, you have a space called Adjusted Gross Income, which you reach after adding all your income from different sources. Tax deductions helps lower this amount by deducting the eligible expenses from that gross income. You can either make it standardized deduction or itemized deduction. Everybody qualifies for deductions regardless of their income level.

Tax credit is different than exemptions and deductions in that it helps reduce your taxes dollar for a dollar amount. For example, you get tax credit when you buy a new home or hybrid car or energy star appliances, they benefits the economy or the environment. Tax credit is determined after your income tax bracket is figured out; therefore, not everybody qualifies for tax credits since it is based on income unlike tax deductions.

Adjustments are also known as Above the Line Deductions. They directly reduce your income since they are payments that you are making. For example, if you own a small business and are self employed then you might have to pay for employee health insurance. This amount can be used to reduce your income.

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