In the U.S. federal tax system, tax deductions and tax exclusions are very similar matters because they both limit or eliminate an individual's tax burden. However, deductions and exclusions are not identical, and those who would like to claim them must have an understanding of what they are and how they work.
The Internal Revenue Service requires United States citizens and qualifying residents with earned income to pay taxes on that earned income. The IRS determines the percentage that they must pay in taxes according to the total amount of taxable income they received for a particular tax year. A tax deduction is a qualifying expense that allows a tax payer to reduce the total amount of income for which he must pay tax. For instance, someone who had a gross income of $50,000 but claimed a deduction worth $10,000 only needs to pay taxes on $40,000 of income.
While tax deductions usually involve some qualifying expense that the tax payer incurs, an exclusion does not. Instead of reducing someone's taxable income, an exclusion is a situation that causes a tax payer to not need to pay tax on income that would otherwise be taxable.
Deductions come as specific expenses that tax payers can identify. Some common deductions are business expenses, charitable donations to qualified organizations, contributions to qualified pension accounts and payment of interest on student loans. For certain types of expenses, the IRS places limitations on the percent of gross income for which tax payers can claim deductions. For other types of expenses, tax payers can claim up to their entire taxable income, removing all need to pay income tax. After reaching the yearly limit, tax payers can sometimes carry over excess deductions to the next tax year.
A common type of tax exclusion that tax payers can claim is the foreign earned income exclusion. If a U.S. citizen resides abroad, she does need to pay income tax for income she has earned for that tax year, regardless of whether or not that income originated from the United States. However, thanks to the foreign earned income exclusion, she does not have to pay tax on income until she income reaches a certain point. For 2011, that point is when her income exceeds $92,900. Another type of tax exclusion is the combat zone tax exclusion. Members of the U.S. Armed Forces who are serving in combat zones do not have to pay taxes on any income related to their military service.
Another way through which tax payers may reduce their income tax burden is through a tax credit. Unlike deductions and exclusions, credits do not reduce the amount of income for which a tax payer must pay tax. Instead, a tax credit is a flat amount of money that a tax payer may subtract from the total amount of money the IRS requires him to pay in income tax.