When you do your taxes, the words “tax deduction”, “tax exemption” and “taxable income” will often come up. What are the meanings of these words? When you look in the dictionary, they’re definitions are even more confusion. The thing is that these words should be understood together, not in isolation. In this blog post, these words will be explained in a way that’s easy to understand and I’ll show you how they’re all linked together.
If you want to watch a video (less than 4 minutes) that explains what taxable income, tax exemption and tax deduction mean and how they interact to reduce tax paid, check this video out (otherwise read on):
I’m going to explain to you what these words mean with this banana. (Why? Because, everyone loves bananas). Assuming this banana represents all the money you’ve earned this year and that you’re single and make money from a job.
Tax is something you have to pay to the government and its calculated on your taxable income.
So the calculation of how much tax you have to pay, kind of looks loosely like this:
TAXABLE INCOME x TAX RATE = TAX YOU HAVE TO PAY.
If that tax rate stays the same, let’s say it’s 10%, if you reduce your taxable income; the tax that you have to pay is less (and paying less that, is generally a good thing for many). See…
TAXABLE INCOME (100) x TAX RATE (10%) = TAX YOU HAVE TO PAY ($10)
TAXABLE INCOME (50) x TAX RATE (10%) = TAX YOU HAVE TO PAY ($5)
So, the taxable generally does not always equal your full income because the tax office might give you discounts so that you can reduce your taxable income, and consequently, the amount of tax you have to pay. So we have to find out what our taxable income is. So let’s get to this amount of taxable income with this banana.
Assuming that is the starting point for the calculation of taxable income. That is the income tax will be calculated on.
Your tax office might offer you an exemption depending on your income level and situation.
If you’re able to get an exemption, this reduces your taxable income.
Think about it as a discount. Let’s say at a shop, a T-shirt is on sale at $10. You only pay 50% of that T-shirt price (let’s pretend that’s the tax paid) but then, the price of the T-shirt gets cut down further from $10 to $2. That $8 reduction is a discount.
So that’s kind of what an exemption is. An exemption is an amount that reduces your taxable income. Using the example about, $10 was the taxable income, now it’s $2 using the $8 exemption. Tax paid is $1 (50% of taxable income) compared to the original $5 (50% of $10 is $5).
So I’m going to slice a portion off this banana. I’m going to leave this piece shaded because it represents money that the tax office said I could keep. So an exemption is just an amount that reduces your taxable income.
Ok, now on to the deduction. A deduction also reduces taxable income, but it’s slightly different.
So during the year when you earned this income, you may have had to pay for gasoline to drive to work, and you may have had to pay alimony, you may have had to move house. This is money that you’ve already spent.
That’s what deductions are there for: to reduce your full income to recognise that you may have spent money so that you don’t have to pay tax on your full income. It’s to make it fairer generally.
But… deductions in the tax office are based on certain rules - they have certain rules on how much you can deduct and what area depending on various things like your income.
Given this, I’m going to slice an amount off this banana to recognise my deduction that the tax office will let me take off my income.
What’s remaining is taxable income (the money you originally made, that’s been reduced by the tax exemption and the tax deduction). Which is the amount, that the tax rate, that % is applied for you to figure out how much tax there is to pay.
Next: Difference between Accrual & Cash Accounting and Impact on Your Business (CPA explains)