It is easy to lump deductions, credits, and exemptions into the same basket of tax-saving mechanisms, but they are distinctly different. One major difference is that the Tax Cuts and Jobs Act of 2017 (TCJA) did away with personal exemptions for the tax years 2018-2025, so you won't be able to use exemptions for a while. Here are the simplified differences:
- What They Reduce – Deductions and exemptions both reduce your taxable income, and credits reduce your overall tax bill. With reference to Form 1040, deductions – and when they apply, exemptions – all take effect before line 11 (your taxable income), and credits are applied after line 12 (the tax you pay on that taxable income).
Deductions and exemptions reduce your taxes proportionally to your tax bracket, but credits reduce your taxes dollar-for-dollar regardless of your tax bracket. In other words, if you are in the 10% tax bracket, a $1,000 deduction saves you $100 on your taxes, but a $1,000 tax credit saves you $1,000 on your taxes.
- Their Basis – Deductions are related directly to expenses you incurred over the course of the tax year. Credits are generally incentives aimed at influencing behavior. Exemptions are only concerned with people and the relationship you have with them; aside from determining whether or not someone is a dependent, they have no financial basis.
Let's look at the three categories in more detail:
- Deductions – Deductions are related to your expenses, but their impact varies based on two criteria – whether they are "above-the-line" or "below-the-line" expenses, and whether they are scaled relative to your income.
The other distinction in deductions is whether they are itemized – a list of individual deductions you can take – or a standard deduction that you can apply. The standard deduction is based on your filing status and has nothing to do with your actual expenses.
"Above-the-line" deductions mean they are used in figuring your AGI, before you have to decide whether to itemize or take a standard deduction. This means you can take these deductions whether you itemize or not. Since the IRS redesigned Form 1040 following the tax overhaul, above-the-line expenses are entered on Schedule 1, a new schedule that should be attached to your Form 1040. "Below-the line" deductions are itemized, and some can only be taken once the expenses exceed a certain percentage of your AGI. This makes above-the-line deductions doubly useful. Below-the-line deductions are still entered on Schedule A.
For tax year 2018, the TCJA almost doubled the standard deduction and, for tax year 2019, it was again raised to $12,200 for filers who are single or married filing separately, $24,400 for married filing jointly, and $18,350 for head of household. This increase in the standard deduction has made itemizing unattractive for many. Under the new law, several of the itemized deductions have been eliminated while the limits on others have been changed.
- Credits – Credits are generally incentives aimed at one of two goals: to influence behavior, such as education credits and residential energy credits; or to address a societal concern, such as the Child Tax Credit or adoption credits. Major credits have a separate line on Form 1040. Rooting out miscellaneous credits and the requisite IRS forms can be time-consuming but could prove to be time well-spent.
To help offset the loss of the personal exemption, the Child Tax Credit has been doubled to $2,000 for each qualifying child from 2018 to 2025, and a new $500 tax credit will be added for non-child dependents.
Some savings, like education costs, can be redeemed as either a credit or a deduction, depending on qualifications for each. Therefore, when trying to decide which is best, remember this hierarchy from generally most effective to least – credit, above-the-line deductions, exemptions (when reintroduced after 2025), and below-the-line deductions. However, all of these are tax savings – so take all to which you are entitled, regardless of their size.
- Exemptions – A higher number of exemptions reduces your taxable income – essentially, this says to the IRS, "these are the number of people I am responsible for." Generally, dependents must be age 18 or younger (except for full-time students), a member of your family or a qualified relative, and must provide less than half of their own economic support. Unfortunately, your pets, while dependent on you, do not qualify as legal dependents in the eyes of the IRS. See IRS Publication 501 for details on who qualifies as a dependent.
When exemptions are in play, you could reduce your taxable income by a set amount of money multiplied by the number of dependents. Exemption amounts would usually be scaled back above certain income levels.
Traditionally, you could not claim a personal exemption for yourself if someone else claims you as a dependent. Use the IRS Interactive Tax Assistant to determine if you can claim someone as a dependent.
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