Deductions, Exemptions and Credits

What are deductions?

An individual's ultimate tax bill is based on the "ability to pay," rather than just the tax rate for his income level. In order to determine a taxpayer's ability to pay, there are rules in place that allow gross income to be reduced by claiming certain specific or "itemized" deductions. For example, a taxpayer with children, a mortgage and high medical expenses has less ability to pay a portion of income to the federal government. By subtracting these expenses, the taxpayer can calculate his "adjusted income." His tax bill is then figured using the adjusted income.

Sidebar: A taxpayer's income is reduced through the "standard" deduction. If the taxpayer's itemized deductions exceed the standard deduction, she uses the larger amount to calculate her taxable income.

Is an exemption the same as a deduction?

Similar to deductions, an "exemption" allows a taxpayer to subtract a set amount from his gross income for each allowable "exemption." Every taxpayer gets to subtract an amount for himself. Married couples, for example, get two exemptions. Additionally, the taxpayer gets an exception for every child or legal dependent. Thus, those taxpayers with large families have a lower adjusted income since their ability to pay is much less than a childless couple.

Sidebar: The Taxpayer Relief Act of 1997 gave certain taxpayers the ability to receive a per-child tax credit. The tax credit was $1,000 per child in 2004, but is slated to drop back down to $700 in 2005 unless Congress changes the amount.

TIP: Because the per child tax credit is a credit, it is possible for taxpayers with very low incomes to not only owe zero taxes, but to get a refund.

Can I claim a child as a dependent who does not yet have Social Security number?

Yes. If your child was born during the tax year, you can attach a copy of the child's birth certificate to your return.

What are dependants?

Every taxpayer may claim an exemption for her dependants. A dependant is not necessarily a child. The IRS allows you to claim a dependent of any age as long as he meets five tests: relationship test, citizenship test, joint return test, gross income test and support test.

What is the relationship test?

A dependent is direct descendant-a child, grandchild, great-grandchild-whether living with you or not. If the dependent is not a relative, the test requires her to live in the household for one year as "member of the household."

If there is no age limit on a dependent, can I claim my child as a dependent as long as I live?

Yes, in rare circumstances. However, once your child is more than 19 years old and earns more than $3,100 per year, you cannot claim him. The exception is children still in school up until age 24. If you continue to support your child the rest of his life and he never earns an income more than $3,100 you can continue to claim him as a dependent.

Can my ex-husband and I split the dependency exemption?

No. The dependency exemption cannot be split. The parent who provides more than half the support for the child gets the exemption. Generally, the custodial parent is assumed to have provided more than half of the child's support and gets the exemption. However, if the noncustodial provides more than half of the child's support, she may be entitled to the exemption.

What is a tax credit?

There are several types of credits available to taxpayers. The credits are directly subtracted from the taxes owed. In 2004, available tax credits included education credits, child credits, earned income credits, credits for the elderly and disabled and dependent care credits.

How does my retirement account affect my income taxes?

Taxpayers can reduce their income for tax reporting purposes by contributing to certain retirement accounts. Generally, these accounts are 401(k) and IRA accounts. For example, an individual can contribute up to $4,000 per year (as of 2005) to an IRA.