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Untangling the tax exemption versus tax deduction versus tax rebate

Posted by Shivali Anand

October 8, 2021    |     6-minute read (1100 words)

Taxpayers are constantly seeking methods to lower their taxable income. Knowing how a tax exemption, deduction and rebate are different can help. But these three terms are frequently confused with one another.

Let's break these terms down here.

  1. Tax deductions
Taxpayers can deduct various personal costs from their taxable income each year, thanks to federal tax legislation. However, the U.S. Internal Revenue Code specifies which items can be expensed and save money on taxes.

Standard deductions: According to the IRS, all taxpayers who do not itemize their deductible costs are entitled to take the standard deduction. Every year, the federal government determines the typical deduction amount for each filing status. It approved a standard deduction of $12,400 for single taxpayers, $18,650 for those filing as head of household, and $24,800 for married couples submitting a joint tax return in 2020, for example. For example, after the standard deduction, a single taxpayer earning $90,000 in a given year would earn $77,600. It's worth noting that you can reduce this sum even more by claiming additional eligible deductions. 

 For the year 2020, the standard deduction allows you to deduct up to $300 in eligible monetary donations per tax return. In 2021, this sum will increase to $600 for married couples submitting joint returns and $300 for other filing statuses.

Above-the-line deductions: For personal income tax returns, the adjusted gross income must be calculated before the final taxable income amount can be determined. Since their restrictions do not influence AGI, deductions are generally less restricted to arrive at AGI than below-the-line deductions (described next).

The student loan interest deduction, for example, lets you deduct the interest you pay on qualifying student loans if you meet the deduction's conditions. Similarly, regardless of AGI, qualifying self-employed health insurance expenses are entirely deductible.

Deductions made below the line: AGI is reduced by deductions done below the line. Several of these deductions have various restrictions that are proportional to the amount of AGI reported. Most of these deductions are linked to the costs shown on Schedule A of a person's personal income tax return. Some frequent itemized deductions include medical and dental expenses, as well as charitable contributions. For the year 2020, only the part of deductible medical expenditures that exceed 7.5% of AGI is included in the deductible medical expenses.

The standard deduction is not available to taxpayers who want to itemize deductions.

Small business deductions: A single proprietor who runs a small business must record all business-related incomes and deductions on Schedule C, a separate computation of the total net profit or loss requiring them to disclose all business-related incomes and deductions.

 On Schedule C, a small company owner can claim any business deduction accessible to all other types of businesses. Staff wages, office rent, advertising, marketing costs, and other reasonable expenses directly related to the company are examples of such deductions.

  1. Tax exemptions
On their tax returns, most taxpayers are entitled to some form of tax exemption that reduces their tax liability. When businesses serve the public, such as religious groups or charities, state and federal governments frequently exempt them from paying income taxes altogether.

Personal exemptions: Before 2018, an individual may claim one personal tax exemption provided they did not claim it as dependent on another taxpayer's return. This is a yearly increase in a set amount. The exemption reduces their taxable income, but there are fewer limits than with a deduction. Both spouses receive an exemption when married couples file a joint return.

Exemptions for dependents: Before 2018, the IRS permitted people to claim more exemptions for each dependent they claimed. Children who reside with them for more than six months are under the age of 19 (or 24 if a full-time student) and do not contribute more than half of their own financial support throughout the tax year are typically eligible for these exemptions. Other dependents might include relatives who live with the taxpayers or parents who do not reside with them.

Tax-exempt businesses: Tax-exempt enterprises must meet all IRS standards to be granted tax-exempt status. Typically, they are non-profit organizations that provide essential community services. A company that gets tax-exempt status is free from paying federal income tax, but it must keep up-to-date and correct documents to preserve that position. Individuals who donate to these organizations may claim a charitable contribution deduction if their donations are itemized.

Exemptions from the state, county, and municipal taxes: To boost the local economy, state, county, and municipal governments give tax exemptions to businesses. For example, if an organization relocates its activities to a specific geographic region, it may be excluded from paying local property taxes. Customers may purchase items without paying state or local sales taxes if cities and states provide sales tax holidays.

  1. Tax rebates
Tax rebates may be issued by federal, state or local governments to urge taxpayers to rapidly revive a sagging economy or make specific purchases by putting cash in their hands. Tax rebate eligibility may vary, but in general, taxpayers do not have to wait until the following year's tax return to get payment. The tax refund check is frequently unrelated to deductions and credits claimed on a return.

Because governments can adopt tax rebate measures at any time during the year, they are generally more promptly received than tax refunds. The Recovery Rebate Credit of 2008, for example, was enacted by the federal government to assist in jump-starting the US economy after a severe downturn. The government hoped that by doing so, taxpayers would be more likely to spend their money right away, boosting the economy.

The 2001 federal tax rebate: When the economy was suffering from the collapse of the dot-com boom in 2001, Congress issued a midyear tax refund to boost consumer spending. Even back then, the government thought that distributing checks, rather than lowering tax rates, would immediately benefit the economy (which happened the following year). According to the National Bureau of Economic Research, the tax rebate helped combat the recession by raising aggregate consumption by 2.9% in the third quarter of 2001 and 2% in the fourth quarter.

Alternative energy tax rebates: Some state and municipal governments offer refunds to encourage purchasing alternative energy systems such as solar panels. Although local states and municipalities handle the reimbursements, the federal government provides a significant portion of the cash for such schemes.

Hybrid car tax rebates: The environment's protection and preservation are a key priority in some municipalities. Some state and municipal governments provide various subsidies to promote the purchase of hybrid automobiles that minimize fuel usage.

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