Tax 101: Deductions, Exemptions & Tax Credits
Deductions
First, a reminder: when you calculate your federal income taxes owed using marginal income tax rates and brackets, you don’t plug in your total (gross) income but rather your taxable income. Your salary and other income might be $80,000, for example, while your taxable income is only $60,000.
To figure out your taxable income, you start with your gross income and then subtract your deductions and exemptions.
So-called “above-the-line” deductions are available to everyone who qualifies (e.g. student loan interest payments, retirement contributions, healthcare expenses, and so on). The “line” in question separates your “gross income” from your “adjusted gross income” (AGI).
Below the line, you choose whether to take the standard deduction (a fixed amount set in law, indexed to inflation) or the sum of your itemized deductions (e.g. charitable donations, mortgage interest payments, etc).
The combined effect of these deductions is to reduce your gross income.
For example, let’s say your neighbor has $300,000 in gross income and $50,000 in deductions available to him (lucky him!)
The income thresholds here track with the Trump tax law for 2024, but are rounded to the nearest $10K for simplicity. The chart isn’t perfectly to scale, either, but you get the idea!
Without that big deduction, his taxes owed would be:
10% x $10,000 = $1000 +
12% x $40,000 = $4,800 +
22% x $50,000 = $11,000 +
24% x $100,000 = $24,000 +
32% x $50,000 = $16,000 +
35% x $50,000 = $17,500
= $74,300
But with that big deduction, he gets to save that last $17,500 (0.35 x 50,000) for a total tax liability of $56,800.
In essence, the deduction comes from the top end of his income. He had $300,000 in gross income, putting $50,000 of his income in the 35% bracket. But if we deduct that last $50 grand from his income, boom! he maxes out in the 32% bracket instead.
The truism about tax deductions—as opposed to tax credits, which we’ll get to below—is that they provide a bigger benefit to higher-income taxfilers than to lower-income ones because the higher your highest bracket is, the bigger your tax discount from a deduction.
I’m not sure that’s super intuitive the first time you hear it, but hopefully it makes sense when you see it laid out graphically like this.
Because if you had that same $50,000 in deductions to subtract from $100,000 gross income, that would be a tax savings of ‘just’ (0.22 x 50,000) = $11,000 compared to the $17,500 savings that the guy with $300,000 in gross income got, even though your deductions are the same.
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Lawmakers have used itemized ductions to incentivize (theoretically, at least) all kinds of pro-social behavior from charitable deductions to home ownership, and more. That’s notable in the context of deductions benefitting wealthier households more than lower-income ones. If both you and your neighbor “itemize” and even if you both give the same amount to charity, your charitable donations are worth less than your neighbor’s just because you make less money than he does. And if you take the standard deduction, your charitable donations are worth nothing at all! Does it make sense to structure tax policy so as to reward those who already have more with more?
For 2018 through 2025, the Trump tax law increased the standard deduction by almost double, offset by eliminating personal exemptions over the same period.
Personal Exemptions
Personal exemptions—when they’re in effect—work the same way as deductions.
Before the Trump tax law, each taxpayer was also able to reduce their gross income by a personal exemption (fixed amount, indexed to inflation) for each person in their household (the taxfiler, spouse, and all qualified dependents) in addition to whatever deductions they took.
The Tax Policy Center has a nice example here:
[P]ersonal exemptions link tax liability to household size. For instance, in 2017 when the personal exemption amount was $4,050 and the standard deduction for a married couple was $12,700, a married couple with three children and income of $92,950 (before subtracting five personal exemptions and the standard deduction) and a married couple without dependents and income of $80,800 (before subtracting two personal exemptions and the standard deduction) had the same taxable income—in this case, $60,000.
In 2017, the personal exemption for each person on a household’s tax return was $4,050. The Trump tax law eliminated personal exemptions from 2018 through 2025. Personal exemptions (adjusted for inflation) are set to return in 2026.
As TPC notes, “By replacing personal exemptions for dependents with expanded child tax credits, [the Trump tax law] moved toward equalizing the tax benefit for children and other dependents across households with different incomes.”
But, like all things connected to the Trump tax law, this change was a mixed bag for tax fairness. Previously, anyone with an individual taxpayer identification number (ITIN) qualified for a personal exemption and any child with an ITIN qualified for the child tax credit. The Trump law limited eligibility for the child tax credit to children with Social Security numbers, so certain families lost both their personal exemptions and their child tax credits.
(There are likely other differences between which dependents qualified for personal exemptions and which qualify for family-related tax credits that also determined whether this was a net-positive or net-negative for impacted households.)
Tax Credits
Unlike deductions and exemptions which lower a taxpayer’s taxable income and therefore give a bigger benefit to those with higher incomes, tax credits provide a dollar-for-dollar reduction of an individual’s final tax liability. That means everyone who qualifies gets the same benefit.
Refundable credits help those low-income taxpayers who end up with no tax liability get money back, even after their taxes owed falls to zero. This can partly offset the federal payroll taxes that working people pay even if they earn too little to owe any federal income tax. It can also partly offset the many regressive state and local taxes that Americans pay, especially sales taxes that affect even the poorest households, and property taxes, which are passed down to low-income tenants as higher rents.
As an example, a household with $6,000 in refundable tax credits and a final tax liability of $4,000 would end up getting that $4,000 wiped clean and a check for $2,000.
