Ten Key Tax Terms to Know
One of the hardest things about taxes is learning the language. You've got all the forms and instructions, but it seems they're harder to decipher than that first lesson in your high school Latin class. Here are 10 key tax terms to help you start talking taxes.
Adjusted gross income, or AGI, is all the income you receive over the course of the year, including wages, interest, dividends and capital gains, minus things such as contributions to a qualified IRA, some business expenses, moving costs and alimony payments. AGI is the first step in calculating your final federal income tax bill.
2. Tax credits
Tax credits are much like credits you get from a store. After you calculate your tax bill, you can use the credit to reduce the amount of the check you must write to Uncle Sam. Tax credits are more valuable than tax deductions because they directly cut the amount of tax you owe, rather than reducing the amount of taxed income. A $200 credit, for example, will turn a $1,000 tax bill into only $800. A few credits could even give you a refund you weren't expecting.
3. Tax deductions
Tax deductions are expenses the Internal Revenue Service allows you to subtract from your AGI to arrive at your taxable income. In most cases, the lower your income, the lower your tax bill. If, for example, a single filer has income of $38,000 and $8,000 in deductions, then he would pay taxes on only $30,000. The IRS offers all filers a standard deduction amount (more on this later).
Some other deductions -- such as student loan interest, moving expenses, deductible IRA contributions and alimony payments -- also are listed directly on the 1040A or long Form 1040. The term "deductions" is most commonly associated with the itemized deductions (more on this later, too) that taxpayers who file Schedule A claim.
4. Standard deduction
This is a fixed dollar amount that taxpayers can subtract from their income. The standard deduction is available to all filers and is determined by the taxpayer's filing status. The amounts change each year because of inflation adjustments. You can find the current standard deduction levels listed on each of the three individual tax forms. Most taxpayers use this deduction method, which eliminates the need to itemize actual deductions such as medical expenses, charitable contributions and state and local taxes.
5. Itemized deductions
These are expenses that can be deducted from your AGI to help you reach a smaller income amount upon which you must calculate your tax bill. Itemized deductions include medical expenses, other taxes (state, local and property), mortgage interest, charitable contributions, casualty and theft losses, unreimbursed employee expenses and miscellaneous deductions such as gambling losses. Some itemized deductions must meet IRS limits before they can be claimed. When you itemize, you must file Form 1040 and detail your tax deductions on Schedule A.
This is an amount the IRS lets you subtract from your income to reflect all the people who count on your income. You can claim as tax exemptions yourself, your spouse and your dependents. The IRS allows a set amount for each exemption and, as with deductions, this total is subtracted from your adjusted gross income to come up with your final, lower earnings amount upon which you must figure your tax bill. Your personal exemption amount is in addition to any tax deductions, either standard or itemized, that you claim.
7. Progressive taxation
This is the system in which higher tax rates are applied as income levels increase. The U.S. tax system uses progressive taxation with tax brackets starting at 10% and rising to 35% for the wealthiest taxpayers.
8. Taxable income
Taxable income is your overall, or gross, income reduced by all allowable adjustments, deductions and exemptions. It is the final amount of income you use to calculate how much you owe in taxes.
9. Voluntary compliance
This describes the philosophy upon which our tax system is based: U.S. taxpayers voluntarily comply with the tax laws and report their income and other tax items honestly.
Also known as pay-as-you-earn taxation, the withholding method enables taxes to be taken out of your wages or other income as you earn it and before you receive your paycheck. These withheld taxes are deposited in an IRS account and you are credited for the amount when you file your return. In some cases, taxes also may be withheld from other income such as dividends and interest.