When discussing income tax, it’s easy to confuse similar-sounding technical terms. The boundaries around tax exemption and tax deduction are particularly blurry.
Although these two types of reductions tend to be used interchangeably, they have separate structures and operate under distinct criteria. Recognizing the differences between exemptions and deductions will help you gain a better understanding of what you owe, and what you can claim.
Tax exemptions are guaranteed on select sources of income but not your income total. In many cases, this means that you won’t have to pay any tax on profits which come from certain, protected channels.
A universal example of tax exemption can be seen at the supermarket checkout, where produce, fresh meat, eggs, and most milk products are not taxed. However, your total grocery bill is still taxable.
Tax exemptions have a long history, going all the way back to the Hebrew Bible, when King Saul offered tax exemption as a reward to anyone who could defeat Goliath. Needless to say, tax laws have evolved significantly since then!
Tax Exemption Scenarios
Sources of income that cannot be taxed federally include most lottery winnings, most gifts and inheritances, most types of strike pay received from a union, and most amounts received from a life insurance policy following a loved one’s demise. We say “most” because the government reserves the right to challenge unique situations.
Even though these sources of income are generally tax-free, it is important to keep in mind that any interest earned on these funds is taxable. For example, if you put an inheritance or gift amount in the bank, the interest it generates will be taxed. Likewise, if you invest such a sum into mutual funds or stocks, any dividends earned on the investment will not be exempt from liability.
Payments for welfare, social assistance, alimony, and child support are exempt from taxes. Most healthcare benefits and reimbursements from qualifying adoptions are also tax-free. Scholarships can qualify as long as they are used specifically on education expenses.
Tax exemptions and deductions often get tangled up in the business sphere, so let’s look at some examples of tax-exempt perks your employer might provide. Meals and lodging offered by your employer aren’t income per se, but you don’t have to add their value to your taxable income. (To avoid any ambiguity, however, the meals or lodging must occur on your employer’s property and at their convenience.)
Some types of employer-provided insurance are also non-taxable – at least up to a certain price. Long-term care insurance, accident and health insurance, or health plan coverage and reimbursement for medical care are generally non-taxable as long as they don’t exceed $50,000. Any runoff over $50,000 will be taxable to you.
There are equally tricky rules surrounding disability insurance payouts and worker’s compensation benefits. If your employer provided (and paid premiums for) a disability policy, those benefits will be taxable, whereas the policy would be non-taxable if you owned it yourself.
Worker’s compensation benefits received lawfully for a work-related ailment are tax-exempt, but that can change if those benefits diminish your Social Security. Be aware that returning to work on light duty can also modify your tax-free status.
Unlike tax exemptions, which can be claimed on select sources of income, tax deductions can be claimed on the gross total income. Since these expenses are subtracted while calculating taxable income, they can lower the amount of tax you have to pay.
These deductions are frequently called “tax write-offs”. While you cannot claim them on strictly personal expenses, most business-related purchases are fair game – as the examples below demonstrate.
Tax Deduction Scenarios
A common example of a legitimate tax deduction is business travel. Since travel expenses were required in order for you to do your job, they can be deducted from your income tax.
Even expenses that are primarily for personal use but have a small business function can be claimed as a partial deduction. If you buy a new laptop and use it for business 10% of the time, you may be allowed to deduct 10% of the cost.
The variety of business expenses has broadened significantly since the advent of remote work. Employees who work from home can deduct the price of their office chairs, desks, and other essential components of their work spaces. In some cases, businesses will even pay a portion of the employee’s utilities to offset the added electricity and internet demands.
Keep Your Receipts
Since the introduction of hybrid and remote work has complicated the issue of tax deductions, it’s a good idea to speak with your accountant or tax company about the latest changes in tax laws. There may be new deductions for which you qualify!
Regardless, it’s more important than ever to hang on to all work-related receipts. That way, if you get audited over your taxes, you’ll be able to back up your claims.
A Note On Tax Credits…
The subject of tax credits could warrant an entirely separate article, but what’s important to note is that they’re distinct from both tax exemptions and deductions. In a nutshell, credits are applied after you’ve calculated your total and reduce your tax bill directly.
While all qualifying tax credits match what you owe dollar for dollar, they exist in refundable, nonrefundable, and partially refundable forms. Nonrefundable tax credits can reduce your liability to zero, while refundable credits can provide a refund for any remaining dollar amounts after zero.
Speak With Your Accountant
Everyone wants to make tax season less complicated and painful. Getting familiar with these types of tax reductions can not only simplify the process of calculating what you owe, but also reduce your liability.
Whether you’re pursuing information on home, health, work, or education-related taxes, there’s a staggering amount of information on exemptions, deductions, and credits for your particular lifestyle. By making an appointment with your accountant or financial advisor, you can learn more about reductions that can save you money.