The moment you start computing taxable income of a person, you will come across the term tax deductions , personal tax exemption and tax credit . Two things about these taxation terms are well established – all three terms are completely different in meaning and application and all of them , ultimately , reduce bring tax relief for Individuals.
In simple terms , the deductions and tax exemptions reduces your taxable income ( so ultimately reduces tax payable , but tax credit is applied to reduce the tax payable directly. In other words, tax credits are reduced after you computed taxable income and tax thereon .
Personal Tax Exemption
What are Tax Deductions ?
Deductions are amounts in form of expense which are allowed to be reduced from income itself . Say, you donated certain amounts to charity or paid interest on educational loan or took home loan and paid interest ……like wise. The tax deductions are always related to some kind of outflow of cash within the tax year and if along with that expenditure , other conditions of a particular deductions are also satisfied , in that case US tax law permit you to deduct the said expenditure from that gross income . Basically you can group these deductions as standard deduction , Above the Line Deduction and itemized deduction ( Below the Line Deduction) .
Standard deduction is announced every year. Read the standard deduction for tax year 2015.
The list of deductions under Internal Revenue Code are as under
- Tax Deductions for Life-Changing Events
- Tax Deductions for Families and Parents
- Tax Deductions for Teachers, Educators
- Tax Deductions for Employees/Workers
- Medical Tax Deductions
- Tax Deductions for Homeowners
- Charity Tax Deductions
- Tax Deductions for Car and Travel
- Student Tax Deductions
You can not claim both standard deduction and itemized deductions ( below the line deductions) which are called together. What is best , should be first compared and then chosen. So, compute all the itemized deductions . If it is more than the standard deduction , claim itemized deduction. Otherwise claim standard deduction. However, Above the line deductions are not affected by this rule. Read more about above the line deduction .
How to Compute Taxable Income ?
In other words , the computation of taxable income can be done as under :
Step1 : Add all your income
Step 2: Deduct the Above the line Deduction
Result : Adjusted Gross Income
Step 3: Find out which one is more beneficial to your -Standard Deduction or Itemized Deduction. Deduct the best one for you
Step 4: Deduct the Personal Tax Exemptions
Result : Taxable Income
Tax credits are deduct after the tax is calculated . So, if you are allowed tax credit, you can reduce the tax payable with this amount. Basically, there are tow types of credits available to individuals. Refundable tax credit and non refundable tax credit.
Refundable tax credit means if the tax credit is more than tax payable , you will get the balance as refund.
Non-refundable tax credit are allowed only upto the tax payable. SO if there is extra -refundable tax credit, you will not get any tax refund.
Please read what are tax credits ?