Tax exemptions and tax deductions both reduce your tax liability by lowering your taxable income. Exemptions relate to your filing status and to the number of dependents you have. In general, the more people in your household, the lower your taxable income. Deductions, on the other hand, are related to actual expenses you have paid during the tax year. In general, the greater your qualified expenses, the lower your taxable income.
For tax year 2012, each exemption is worth a $3,800 reduction in your taxable income. You are allowed one exemption for yourself, provided that no one else can claim you as a dependent. If you are married and filing jointly, you may take a second exemption for your spouse. Finally, you may take an exemption for any dependents you claim. Generally, your dependents are your children who are under 19 -- or under 24 and full-time students -- who are living at home and who provide less than 50 percent of their own support. Occasionally you may also take an exemption for a "qualifying relative" -- a person whom you support -- if they qualify under certain IRS guidelines.
The standard deduction, for tax year 2012, is $5,950 for a taxpayer filing as single and $11,900 for a married couple filing jointly. All taxpayers can choose the standard deduction without documenting any of their expenses. If you do not have a lot of expenses that are allowable under itemized deductions, you typically will be better off taking the standard deduction. If you are not sure which is the best option, the IRS recommends calculating your deductions both ways, and choosing whichever lowers your taxable income the most.
Itemized deductions include certain medical and dental care expenses, local and state taxes, home mortgage interest, charitable contributions, and certain business and educational expenses. Although you stand to save on your tax bill if you have a lot of these expenses and choose to itemize, it's important to document everything and keep financial statements and receipts that support the figures you use, should the IRS ever ask for proof of the amounts.
There are some special deductions that are referred to as "above-the-line deductions," so named because they appear on Form 1040 above the line where the taxpayer calculates his adjusted gross income. These deductions can be taken by any eligible taxpayer, whether or not you choose to itemize. Some of the above-the-line deductions include traditional IRA contributions, student loan interest, Health Savings Account contributions, classroom expenses paid by teachers, and self-employment taxes.
- IRS: Publication 501 - Main Content
- Bankrate: Above-the-line deductions
- Oblivious Investor: The Difference Between Exemptions, Deductions, and Credits
- fivecentnickel.com: What’s the Difference Between Tax Exemptions and Tax Deductions?
- IRS: In 2012, Many Tax Benefits Increase Due to Inflation Adjustments
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