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May 10, 2016

Those Vexing Tax Terms...Exemptions, Deductions, Dependents, Oh My!

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I got a question from a teacher who wanted some ideas on how to bring these tax terms to life for her students. I haven’t developed this into a formal lesson (yet), but I wanted to get this out there in hopes that it will help someone else who is struggling with these concepts also. Enjoy!

 

How can you legally cheat the taxman? Here are two ways to reduce your taxable income legally!

  • Exemptions: Think of exemptions as related to people. For example, your parents can reduce their taxes by $4,050 (2016 rate per exemption) for every person in the household (including children and relatives that qualify as Dependents). So in 4 person household (Mom/Dad) and two kids, the parental income can be reduced by $16,200 ($4,050 X 4).  
    • In fact, my Dad would contribute to our college fund based on the amount of the after-tax impact of exemptions. So, reducing his income by $4,000 for each child, saved him about $1,200 in taxes if he was in 30% tax bracket so that is what he would give to us.  
    • Here’s a helpful formula: Total Exemptions = Personal Exemptions (parent + spouse) + Dependent Exemptions (child or relative)
    • How many exemptions do you think your parent(s) can take given your family situation?
  • Tax Deductions are another way to reduce your income. Tax Deductions are expenses incurred by the taxpayer for things like contributions made to charity, student loan interest deduction or mortgage interest deductions. Tax policy uses deductions as a way to encourage certain behavior (e.g., giving to charity, going to college and owning a home). 
What are Dependents? Hint: You Are Probably One Yourself!
  • Think of Dependents as a subset of Exemptions. Each Dependent = one exemption. 
    • Who can be a dependent: Qualifying child (rules below) or qualifying relative (rules below)
    • Here is a fifteen minute online interactive that you can use to determine who is a dependent (tough sledding for high schoolers!)
    • If you are dependent on your parent(s) tax return, then you cannot claim a personal exemption
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OK, so I know my Exemptions and my Tax Deductions and that they can reduce my taxable income and therefore my taxes. Now what? 
 
Well you have to do some math to figure out Which is BIGGER: Your Exemptions + Tax Deductions OR THE STANDARD DEDUCTION. In other words, all the work we just did may have been for naught! So, here is our BIG QUESTION:
 
Am I better off itemizing or taking the standard deduction? 
  • To itemize means to add up your EXEMPTIONS and TAX DEDUCTIONS 
  • The STANDARD DEDUCTION is a number the U.S. tax law says you can use to reduce your income based on your filing status:
    • For single person: $6,300
    • Married (filing jointly): $12,600
    • I purposely left out head of household or married filing separately
The best way to teach the difference between itemized and standard deduction is to create a set of facts for students to work through about a few taxpayers. Start by saying that taxpayers have to do some math (or tax software like TurboTax to see if they are better off itemizing their deduction or using the standard deduction). The answer will differ based on the set of facts. 
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Simplified examples:
 
A. Jill is 22, single and living independently. She just graduated college, have a job paying $40,000/year. She donated clothing of $500 to Goodwill and paid $2,000 in student loan interest in 2015. Should she itemize or take the standard deduction?
 
Itemize = Exemptions + Tax Deductions
             = ($4,050 X 1 exemption (Jill)) + $500 (donation to Goodwill) + $2,000 (student loan interest) = $6,550
 
Standard Deduction for single person = $6,300
 
She should Itemize!
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B. James is 19 and earned $4,000 at his summer job between years at college. His parents listed him as a dependent on their tax return. He had no tax deductions to speak of. When he files his tax return, Should he itemize or take the standard deduction? 
 
Itemize = Exemptions + Tax Deductions
             = 0 exemptions (if parent(s) list you as dependent, you can’t take the $4,050 exemption for yourself) + $0 Tax Deductions
             = $0
Standard deduction for single person = $6,300

He should take standard deduction! In fact, he would have no taxable income, since his earned income of $4,000 is below the standard deduction of $6,300. If he paid federal income tax during the year, he would receive a refund. 
 
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Other ideas on how to teach it:
Fill in the blank:
1. _________________________________ and ________________________________ are legal ways that you can reduce your taxable income. (exemptions and tax deductions)
2. James chose to use the ____________________________________ which meant he didn’t need to _______________________________. (standard deduction, itemize)
3. Your total exemptions are equal to _________________________________ plus _______________________________________ (personal exemptions, dependent)
4. True or false. If you are claimed as a dependent on someone else’s tax return, you can still take advantage of the personal exemption when you file your individual tax return (FALSE).
5. When you itemize on your tax return, you are including _________________________________ + __________________________________ (exemptions, tax deductions)
6. If your taxable income is under the standard deduction (for a single person) amount of __________________________, you will likely not be responsible for paying any federal income tax ($6,300).
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Webquest idea: Also, could send students out to the web and say they have to write a paragraph explaining each of the terms and explaining their relationship to each other. It might be fun (in a diabolical kind of way) to have them struggle with it before you bring clarity to it. This is not easy stuff!

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.

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