Income taxes can significantly reduce the size of your paychecks because employers withhold a portion of your pay to the government to cover your tax obligation. When you file your income tax return, you may get some of your money back in the form of a tax refund. A tax exemption is a type of tax break that reduces taxable income and can increase tax refunds.
A tax exemption is a tax break that reduces your total taxable income. The government offers two types of tax exemptions: personal exemptions and dependent exemptions. You can claim a personal exemption for yourself as a single taxpayer and if you file a joint return, you can claim a personal exemption for your spouse as well. You can also claim one exemption for each of your dependents. A dependent is generally someone who lives with you and relies on you for financial support, such as a child under the age of 19, a disabled family member or an elderly parent with low annual income.
Each exemption you claim reduces your taxable income by $3,800 for the 2012 tax year. The impact of a tax exemption on your tax refund depends on your income tax bracket. For example, if your filing status is "single" and if your taxable income in 2012 was $60,000, you are in the 25 percent tax bracket for 2012, so a $3,800 exemption reduces your tax bill by $950. At maximum, if you were in the 35 percent tax bracket, the exemption would boost your tax refund by $1,330.
A tax deduction is similar to a tax exemption in that a deduction also reduces taxable income. The main difference between deductions and exemptions is that you can always claim the personal exemptions and dependent exemptions you qualify for, but you may not benefit from claiming all of your deductions. When you file an income tax return, you have to choose whether to use a fixed standard deduction provided by the government or the sum of your "itemized deductions." Itemized deductions include a wide variety of costs, such as real estate taxes, home mortgage interest and gifts to charity. Some taxpayers save money by claiming the standard deduction instead of itemizing.
Unlike exemptions and deductions, tax credits directly reduce the amount of tax you owe instead of reducing taxable income. This means a tax credit can increase your tax refund more than an exemption or deduction of the same size. For example, a tax credit of $3,800 would reduce your total tax bill by $3,800, instead of a percentage of $3,800 based on your income tax bracket.