What is a Personal Allowance?
A personal allowance is the amount of income an individual can earn before becoming liable for income tax. In the U.S., this concept closely relates to the standard deduction and exemptions in the tax code. Understanding how personal allowances work can help taxpayers optimize their tax liability and retain more of their earnings.
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How Personal Allowances Work
The personal allowance reduces taxable income. If a taxpayer earns $50,000 and the personal allowance is $12,000, they only pay tax on $38,000. This allowance adjusts based on factors such as marital status, dependents, and additional deductions.
Standard Deduction vs. Personal Exemptions
The U.S. Tax Cuts and Jobs Act (TCJA) of 2017 eliminated personal exemptions but increased the standard deduction. Here’s a comparison:
| Year | Standard Deduction (Single) | Standard Deduction (Married Filing Jointly) | Personal Exemptions (Pre-2018) |
|---|---|---|---|
| 2017 | $6,350 | $12,700 | $4,050 per person |
| 2018 | $12,000 | $24,000 | Eliminated |
| 2023 | $13,850 | $27,700 | Eliminated |
The shift from personal exemptions to a higher standard deduction simplified tax filing for many households but also affected how families with multiple dependents calculate their tax benefits.
How the Standard Deduction Works
The standard deduction reduces taxable income and varies based on filing status. In 2023, the amounts are:
| Filing Status | Standard Deduction (2023) |
|---|---|
| Single | $13,850 |
| Married Filing Jointly | $27,700 |
| Head of Household | $20,800 |
| Married Filing Separately | $13,850 |
For example, if a single filer earns $50,000, their taxable income is:
50,000 - 13,850 = 36,150Itemized Deductions vs. Standard Deduction
Taxpayers can choose between itemizing deductions or taking the standard deduction. Itemizing makes sense if deductible expenses exceed the standard deduction. Common itemized deductions include:
- Mortgage interest
- State and local taxes (SALT) capped at $10,000
- Medical expenses exceeding 7.5% of AGI
Consider a taxpayer with the following deductions:
| Expense | Amount |
|---|---|
| Mortgage Interest | $6,000 |
| State and Local Taxes | $10,000 |
| Medical Expenses | $5,000 |
| Charitable Contributions | $3,000 |
| Total | $24,000 |
Since $24,000 is less than the standard deduction of $27,700 (for married filing jointly), they would take the standard deduction instead.
Adjusted Gross Income (AGI) and Taxable Income
AGI is a key figure in tax calculations. It is computed as:
AGI = {Gross Income} - {Above the Line Deductions}Above-the-line deductions include:
- Student loan interest
- Educator expenses
- IRA contributions
Once AGI is determined, taxable income is:
{Taxable Income} = AGI - {Standard or Itemized Deduction}Impact of Tax Brackets
After computing taxable income, tax liability is determined using tax brackets. In 2023, the tax brackets are:
| Tax Rate | Single Filer | Married Filing Jointly |
|---|---|---|
| 10% | $0 – $11,000 | $0 – $22,000 |
| 12% | $11,001 – $44,725 | $22,001 – $89,450 |
| 22% | $44,726 – $95,375 | $89,451 – $190,750 |
| 24% | $95,376 – $182,100 | $190,751 – $364,200 |
If a single filer has $36,150 in taxable income, their tax liability is:
(11,000 \times 0.10) + (25,150 \times 0.12) = 1,100 + 3,018 = 4,118Tax Credits vs. Personal Allowances
While personal allowances and deductions reduce taxable income, tax credits directly reduce tax liability. Key tax credits include:
- Child Tax Credit: $2,000 per qualifying child
- Earned Income Tax Credit (EITC): For low-income earners
- American Opportunity Tax Credit (AOTC): For higher education expenses
Example Calculation
A married couple with two children and an AGI of $80,000 files jointly. Their taxable income is:
80,000 - 27,700 = 52,300Their tax liability is calculated as:
(22,000 \times 0.10) + (30,300 \times 0.12) = 2,200 + 3,636 = 5,836With two Child Tax Credits:
5,836 - (2 \times 2,000) = 1,836Conclusion
Understanding personal allowances, deductions, and tax credits helps optimize tax savings. By knowing how to apply these correctly, taxpayers can lower their tax burden and make informed financial decisions.
