Taxes Made Simple

Exemptions

Deductions

Itemized Deductions or Standard Deduction?

1. The sum of all of your itemized deductions, or
2. The standard deduction ($5,700 for a single taxpayer in 2009, or $11,400 for a married couple filing jointly).

Above the Line vs. Below the Line Deductions

If a deduction does not fall into the category of itemized, or “below the line,” it must be what is known as an “above the line” deduction. Above the line deductions are unique in that you can claim them regardless of whether you choose to use the standard deduction or your itemized deductions.

Some common above the line include contributions to a traditional IRA, interest paid on student loans, or contributions to a Health Savings Account.

In contrast to above the line deductions, which are always useful, below the line/itemized deductions are only valuable if and to the extent that they (in total) exceed your standard deduction amount. Here’s how it looks mathematically:

    Gross Income (sum of all your sources of income)
— Above the line deductions
=  Adjusted Gross Income ← “The Line”
— Standard Deduction or Itemized Deductions
— Exemptions
=  Taxable Income


EXAMPLE: Eddie is a single taxpayer. During the year he contributes $3,000 to a traditional IRA, and he makes a charitable contribution of $1,000 to Kiva.org (his favorite non-profit). He has no other deductions, and his income (before deductions) is $50,000.

The IRA contribution is an above the line deduction, and the charitable donation is a below the line (a.k.a. itemized) deduction.
Plugging this into the above equation, we get this:

    $50,000 Gross Income
— $3,000 Above the line deductions
=  $47,000 Adjusted Gross Income ← “the line”
— $3,650 Exemption
— $5,700 Standard deduction
=  $37,650 Taxable Income

Important observations:

1. Eddie’s itemized deductions ($1,000) are less in total than his standard deduction ($5,700). As such, Eddie’s charitable contribution doesn’t provide him with any tax benefit, because he’ll elect to use his standard deduction instead of his itemized deductions.
2. Eddie’s above the line deduction provides a tax benefit even though he’s using the standard deduction.

Again, itemized/below the line deductions only help when they add up to an amount greater than your standard deduction. Above the line deductions, on the other hand, are always beneficial.

Credits

Unlike deductions and exemptions, credits reduce your taxes directly, dollar for dollar. After determining the total amount of tax you owe, you then subtract the dollar value of the credits for which you are eligible. This makes credits particularly valuable.

Credits arise from a number of things. Most often, though, they are the result of the taxpayer doing something that Congress has decided is beneficial for the community. For example, you are allowed a credit of up to $1,800 for paying “qualified education expenses” for one of your dependents. If you meet the requirements  to claim the maximum credit, your tax (not taxable income) will be reduced by $1,800.

“Pre-Tax Money”

You’ll often hear the term “pre-tax money,” generally in a context along the lines of “Hey, I just found out I can pay for [something] with pre-tax money!” This can generally mean one of two things:

1. The item is deductible, or
2. The item can be paid for automatically in the form of a deduction from your paycheck.

The reason these situations are sometimes referred to as “pre-tax” is that you get to spend this money before the government takes their cut. This makes it more cost-effective for you.

You will, from time to time, run across people who seem to be under the impression that something is free simply because it’s deductible or because they were allowed to spend pre-tax money on it. This is a severe misunderstanding. Being able to spend pre-tax money on something is much more akin to getting a discount on it than it is to getting the item free.

Simple Summary

• You are entitled to one exemption for yourself, one for your spouse, and one for each of your dependents. Each exemption reduces your taxable income by $3,650.
• Deductions arise from your expenses, and they reduce your taxable income.
• Each year, you can use either your standard deduction or the sum of all your itemized (below the line) deductions.
• Above the line deductions are particularly valuable because you can use them regardless of whether you use your standard deduction or itemized deductions.
• Credits, unlike deductions and exemptions, reduce your tax directly (as opposed to reducing your taxable income). Therefore, a credit is always more valuable than a deduction of the same amount.

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