The U.S. tax code is one of the hardest sets of laws to understand. Even professionals have trouble with many tax terms, but it's crucial to know what key terms and phrases mean if you want to have any hope of doing your taxes right.
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To explain some of the most important and confusing phrases in the tax laws, we turned to five Motley Fool contributors to put their tax knowledge to the test. Test yourself and see if you know what all of these terms mean and why they're important.
Dan Caplinger: One term that confuses many people is marginal tax rate, which is the tax rate that applies to the last dollar of income you earn. Some taxpayers mistakenly think that if you earn an extra dollar that puts you into a higher tax bracket, you'll have to pay a higher tax rate on all of your taxable income. The way it actually works, though, is that when you poke into a higher tax bracket, you still get to take advantage of lower tax brackets with most of your income, and only that last marginal amount is taxed at the higher rate.
Knowing your marginal tax rate is important to understand how much tax you'll pay on any increase in your taxable income, as it can drive new investment decisions that you expect to produce additional income and have tax implications. For instance, those with higher marginal tax rates benefit more from tax-free municipal bonds, as their taxable-equivalent yield is higher than for those with lower marginal tax rates. Similarly, the value of deductions is less when you have a low marginal tax rate, as the reduction in taxable income produces a smaller reduction in tax liability. To make the best moves with your money, understanding and using your marginal tax rate is essential.
Dan Dzombak: One set of terms every American should know is this: gross income; adjusted gross income, or AGI; and modified adjusted gross income, or MAGI. These are not to be confused with taxable income, which Asit talks about below.
Gross income is the simplest of the three. It is all the income you brought in during the year with no adjustments, credits, exemptions, or anything else lowering it.
Adjusted gross income is your gross income minus various adjustments, including but not limited to retirement plan or health savings contributions, alimony payments, self-employed health insurance payments, self-employment tax, moving expenses, and student loan interest. You calculate your AGI on Form 1040, and it affects what credits and exemptions you can take.
Modified adjusted gross income affects whether your retirement plan contributions are tax deductible, as well as a whether you are eligible for a whole host of other credits and tax deductions. To calculate your MAGI, you need to you can see here, then subtract any passive income you earned, including rental property that you did not manage.
: If you come across the term "taxable income," you should be aware that it has two distinct meanings.
The first is the concept of income that is "taxable" versus "nontaxable." Taxable income includes wages, interest, and dividends, as well as income from self-employment, farming, real estate, partnerships, corporations, and trusts. It also includes the taxable portion of Social Security benefits, some types of retirement distributions, and other miscellaneous forms of income.
Do you see a pattern here? Income from almost any source you can think of is taxable unless otherwise designated by the Internal Revenue Code -- that's the system of tax law by which the IRS functions. For example, municipal bond interest is designated by "the code" as nontaxable income for federal tax purposes, although in some cases it might be taxable at the state or local level.
"Taxable income" also refers to a specific line item on the federal 1040 tax return you and I have to file each year. After adjusted gross income is determined, and a taxpayer then subtracts his or her allowable deductions and tax exemptions, what's left is listed on line 43 of Form 1040 as "taxable income."
Taxable income on line 43 is the total used to determine the amount of tax that will be paid. Line 43 income might be increased by a few other types of tax (such as the self-employment tax), but at this point your tax liability can only be reduced by credits and any withholdings or other estimated tax payments you've made during the year.
Matt Frankel: One tax term that many people have heard of but aren't quite sure of its meaning is "marriage penalty."
For starters, this isn't an official tax term -- the IRS doesn't literally penalize people for being married. The marriage penalty refers to the fact that some married couples pay higher taxes than they would if they were both single and filing separately. There are a couple reasons for this.
First, the tax brackets are higher for married people, but aren't twice as high. As an example, the upper limit for the 28% tax bracket is $189,300 for single filers and $230,450 for married taxpayers filing jointly. So, consider a married couple in which both partners have taxable income of $150,000 per year. If they were single, they would each have a marginal tax rate of 28%. However, their combined income as a marred couple places them in the 33% tax bracket.
The other reason married couples could pay more taxes is because of the income limits on certain tax deductions. For example, in order to deduct mortgage insurance, your income must be less than $100,000, regardless of whether you're single or married filing jointly. If you and your spouse each have $75,000 in taxable income, you are ineligible to deduct mortgage insurance expenses, while single taxpayers with your income could take advantage of that deduction.
Jason Hall: Two common tax terms that people use tax deduction and tax credit -- can sound similar, but mean quite different things.
A tax deduction is something all of us take advantage of each year. When you file your taxes, you'll choose either a standard deduction or to itemize. In itemizing you claim your actual costs for certain things, such as contributions to a traditional IRA, charitable donations, or eligible expenses like business mileage or travel for which your employer doesn't reimburse you, in order to lower your taxable income. If you claim $20,000 in tax deductions, and your taxable income before those deductions was $100,000, your taxable income would in theory then be $80,000, meaning you don't have to pay taxes on $20,000 of your income. In other words, a deduction decreases your taxable income.
However, a tax credit reduces your taxes by the full amount of the credit. Oftentimes, tax credits are used as incentives to expand the markets for things that are viewed as being in the public good, such as alternative-fuel vehicles and solar panels. So if you installed a solar system and got a $5,000 tax credit, it's truly $5,000 in tax savings.
There are also some income tax credits for things like child and dependent care, adoption expenses, along with earned income credits for low and moderate income families with children.
In summary, a deduction reduces taxable income, while a credit directly reduces tax.
The article 5 Tax Terms Every American Should Know originally appeared on Fool.com.
Asit Sharma has no position in any stocks mentioned. Dan Caplinger has no position in any stocks mentioned. Dan Dzombak has no position in any stocks mentioned. Jason Hall has no position in any stocks mentioned. Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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