Everyone Likes Being Excluded

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You probably understand by now, if you're a decently functioning adult, the concept of gross income, deductions and exclusions when it comes to filing your income taxes. But what exactly are the differences between the two and how does this help you to save money?

First, I would like for you to understand how exactly personal income taxes are computed. Your income (which is generally known as "broad sense") is inclusive of everything you've received as some form of compensation during the year, whether or not received in cash. What does this mean? Let's say for example, Joe Smith needs to run an errand for work off-site. Instead of compensating him for the extra time off the clock that he worked off-site, the company pays for him to have a nice meal and a cocktail. The cost of the meal and the cocktail must be included in his gross income, even though it was not compensation received with cash. Joe must also save the receipt to present to his tax preparer, especially if this arrangement with his employer happens frequently.

There are three different types of tax subsidies that reduce the ultimate amount of money that a taxpayer will be liable for (called the "tax basis):

• Tax Exclusion

• Tax Deduction

• Tax Credit

Each one of these subsidies all go to reduce a taxpayer's overall liability, but the way each subject is calculated and applied are very different. In order to manage your taxes better, figure out clever ways to reduce your liability by rearranging factors in your everyday life and defer other liabilities (this process is known as "tax avoidance," which is completely legal and achieved through proper tax planning), you must understand how each type of reduction aspect is treated.

Tax Exclusion

Tax exclusions are cash outflows produced by the taxpayer during the relevant tax year that are not reported as income. The IRS has different reasons as to why certain items are excluded from taxable income. For the everyday taxpayer, the most important thing to know is what qualifies as an exclusion.

401(k) contributions are a good example of exclusions from taxable income. What makes plans such as 401(k)s so appealing to taxpayers is the fact that the contributions are tax free and tax deductible until they are to be used. The downsides of 401(k)s tend to be that there are contribution caps annually (not to be confused with certain types of IRA's, who impose penalties for excessive contributions rather than rejection of excess contributions).

Tax Deduction

This is the most commonly used term for items that are used to reduce tax liability and we as financial professionals tend to cringe when we hear other people use the term so loosely.

Deductions reduce the overall amount of taxable income a taxpayer is liable for. There are above-the-line deductions, which are items that a taxpayer may subtract from their gross income to arrive at their adjusted gross income or AGI.

Now, there is the famous standard deduction. The standard deduction is a blanketed deduction amount applied across the board to all taxpayers within a certain circumstancial bracket. Generally, the standard deduction is used on a regular basis unless the taxpayer has certain circumstances with his/her taxes that will require their deductions to be itemized. A taxpayer may use the standard deduction or the aggregate of their itemized deductions, but are prohibited from using both.

Itemized deductions are line-by-line delineations of cash output situations a taxpayer may face during the year, that are deducted separately from each other. For example, alimony payments as well as home mortgage payments are items that are listed separately and deducted line-by-line.

Tax Credits

Tax credits are dollar-by-dollar reduction of a taxpayer's adjusted gross income or AGI. Tax credits are blanketed rates applied across the board to all taxpayers, regardless of the taxpayer's income tax bracket.

Tax credits are especially helpful because they will under all circumstances, reduce a taxpayer's taxable income. However, most tax credits are not refundable unlike and the amount of the tax credit applied cannot exceed a taxpayer's income tax liability, although there are some tax credits that provide exceptions to this doctrine.

Tax credits also carry prerequisite tests that relevant circumstances must meet, in order for the respective taxpayer to qualify for the desired credit.

A good example of a tax credit is the Child Tax Credit. The Child Tax Credit allows a kickback of $2,000 (so basically, in all sense of the word, a bona-fide credit) for each qualifying child of a taxpayer. However, your income must not exceed $200,000 for a taxpayer filing as Single, Head of Household or Married Filing Separate. If you are Married Filing Joint, your combined income cannot exceed $400,000. The child also must have lived with the taxpayer for half of the past year or more, must be under the age of 16 and also must have had 51% or more of their support provided to them by the taxpayer. The qualifying child also cannot have filed a joint return with anybody else. If all of these tests are met, the taxpayer qualifies for the Child Tax Credit.

In a nutshell,

Nobody likes paying taxes and everybody wants to do everything they can to reduce them. Understanding how the tax system works a bit better can guide you here one step at a time. Managing your assets and taxes is the best thing you can do for yourself, your loved ones and your future.