When discussing income tax, it’s easy to confuse similar-sounding technical terms, especially tax exemptions and tax deductions.
While these two types of reductions are often used interchangeably, they have distinct structures and operate under different criteria. Understanding the differences between exemptions and deductions will help you better grasp what you owe and what you can claim.
Tax Exemptions
Tax exemptions apply to specific sources of income, not your entire income. This means you won’t have to pay taxes on certain protected income streams.
A common example of tax exemption is seen at the supermarket checkout. Produce, fresh meat, eggs, and most milk products are exempt from tax, although your total grocery bill may still be taxable.
Tax exemptions have a long history, dating back to the Hebrew Bible, where King Saul offered a tax exemption to anyone who could defeat Goliath. While tax laws have evolved significantly since then, the concept of exemptions remains integral to modern tax systems.
Tax Exemption Scenarios
Sources of income that are typically not taxed federally include most lottery winnings, gifts and inheritances, certain types of strike pay received from a union, and amounts received from a life insurance policy after a loved one’s passing. We use “most” because the government can challenge unique situations.
Although these sources of income are generally tax-free, any interest earned on them is taxable. For instance, if you deposit an inheritance or gift into a bank account, the interest generated will be taxed. Similarly, if you invest such funds in mutual funds or stocks, any dividends earned are subject to tax.
Payments for welfare, social assistance, alimony, and child support are also exempt from taxes. Most healthcare benefits and reimbursements from qualifying adoptions are tax-free as well. Scholarships may qualify as tax-free, provided they are used specifically for educational expenses.
Business Exemptions
Tax exemptions and deductions often get mixed up in the business world, so let’s clarify some examples of tax-exempt perks your employer might provide. For instance, meals and lodging offered by your employer aren’t considered income, and you don’t need to include their value in your taxable income. However, to avoid any ambiguity, these meals or lodging must be provided on your employer’s property and for their convenience.
Certain types of employer-provided insurance are also non-taxable up to a certain amount. Long-term care insurance, accident and health insurance, or health plan coverage and reimbursement for medical care are generally non-taxable as long as the total value doesn’t exceed $50,000. Any amount over $50,000 will be taxable to you.
Disability insurance payouts and worker’s compensation benefits come with their own set of tricky rules. If your employer provided and paid premiums for a disability policy, those benefits will be taxable to you. Conversely, if you own the policy yourself, the benefits are non-taxable.
Worker’s compensation benefits received lawfully for a work-related injury or illness are tax-exempt, but this status can change if these benefits reduce your Social Security payments. Additionally, returning to work on light duty can also affect your tax-free status.
Tax Deductions
Unlike tax exemptions, which apply to specific sources of income, tax deductions can be claimed on your total gross income. These deductions, often referred to as “tax write-offs,” are subtracted from your total income when calculating your taxable income, thereby reducing the amount of tax you owe.
While personal expenses generally don’t qualify, most business-related purchases do. Here are some examples of common tax deductions:
- Business Travel and Meals: Costs incurred for business travel, including meals, can often be deducted.
- Home Office Expenses: If you have a dedicated home office space, you can deduct related expenses, such as a portion of your rent or mortgage, utilities, and office supplies.
- Education Expenses: Certain education expenses related to maintaining or improving your business skills may be deductible.
- Supplies and Equipment: Items necessary for conducting business, from office supplies to larger equipment purchases, can be deducted.
These deductions help lower your taxable income and, as a result, reduce your overall tax liability.
Tax Deduction Scenarios
A common example of a legitimate tax deduction is business travel. Since travel expenses are necessary for you to perform your job, they can be deducted from your income tax.
Even expenses primarily for personal use but partially for business can be claimed as a partial deduction. For instance, if you buy a new laptop and use it 10% of the time for business, you may be allowed to deduct 10% of the cost.
The variety of business expenses has broadened significantly with the rise of remote work. Employees who work from home can deduct the cost of office chairs, desks, and other essential components of their workspaces. In some cases, businesses may even cover a portion of the employee’s utilities to offset the added electricity and internet demands.
Keep Your Receipts
With the introduction of hybrid and remote work complicating tax deductions, it’s wise to consult your accountant or tax company about the latest changes in tax laws. You might discover new deductions for which you qualify!
Regardless, it’s crucial to keep all work-related receipts. This way, if you’re audited, you’ll be able to support your claims.
A Note On Tax Credits…
The topic of tax credits could easily fill an entire article, but what’s crucial to understand is that they are different from both tax exemptions and deductions. In essence, credits are applied after you’ve calculated your total tax liability and directly reduce your tax bill.
All qualifying tax credits reduce your tax bill dollar for dollar, but they come in three forms: refundable, nonrefundable, and partially refundable. Nonrefundable tax credits can reduce your tax liability to zero, while refundable credits can provide a refund for any remaining amount after reducing your liability to zero.
Speak With Your Accountant
Everyone aims to make tax season less stressful and more manageable. Understanding the various types of tax reductions can not only simplify the process of calculating your tax bill but also reduce your overall liability.
Whether you’re seeking information on home, health, work, or education-related taxes, there’s a wealth of information on exemptions, deductions, and credits tailored to your lifestyle. Scheduling an appointment with your accountant or financial advisor can help you discover the specific reductions that can save you money.