Tax Terms 101: The Words You Need to Know
Benjamin Franklin once wrote that “nothing can be said to be certain, except death and taxes.” He could have also said that nothing is more feared and misunderstood than death and taxes. Part of the reason why taxes either make our eyes glaze over or send us jumping behind the couch is due to the heaping number of tax terms thrown at us.
That’s why we want to demystify the tax process by explaining the most common tax terms. Now you’ll no longer have to pretend to understand when someone talks about their exemptions or their AGI. Here’s ten of the most commonly used tax terms and explanations as to what they mean.
Gross income might sound like an alternate term for dirty money, but it’s actually the opposite. The term refers to the total amount of income you earned throughout the year. This includes wages, tips, bank account interest, dividends and capital gains.
Adjusted Gross Income (AGI)
Once you’ve calculated your gross income, you can figure out your adjusted gross income. You’ll need to subtract deductions such as IRA contributions, some business expenses, moving costs and alimony payments. You’ll use your AGI to determine your taxable income.
Here’s one of those tax terms that sounds exactly as it is. Your taxable income is the amount that Uncle Sam is able to tax you. You determine your taxable income by subtracting your exemptions and deductions from your AGI. The lower you can get this number, the less Uncle Sam can get. This is why you’ll want to take advantage of any available deductions or exemptions.
The IRS allows you to reduce your taxable income if you have dependents or are married. Each exemption lowers your tax bill. In general, you can claim one exemption for yourself, your wife and for each child. When you start a new job, you’ll have to fill out a W-4 form that contains a section for exemptions. If you are unmarried and have no children, then you fill this section with either a 0 or 1. A 0 means that the employer takes out the maximum amount in taxes, while 1 means you are single and have one job. Both options likely result in a tax return at the end of the year.
As the name implies, these are various items or expenses that you can deduct from your taxable income. You can either itemize your deductions or take a standardized deduction. The right choice depends on your career and yearly expenses. Itemized deductions work best for those who are self-employed, since you can deduct many of the expenses involved in running a business. This includes equipment, technology and even office rent, as long as you don’t own the property. Itemizing also works for those who spend heavily on healthcare, charitable donations or similar expenses. Otherwise, you can opt for the simpler standardized deduction. We’ll explain each in the next section.
If you choose to itemize your deductions, you’ll need track the expenses that you can deduct from your taxable income. Secure a consistent place to keep your receipts and records, rather than toss them into your junk drawer. While you have wide latitude over what you can deduct, some expenses may only be deducted if they exceed 2% of your AGI. Check out the IRS website to see which deductions can be itemized and which expenses are subject to the 2% rule.
Those who elect not to itemize their deductions can take a standardized deduction. The amount of the deduction depends on your filing status. Joint filers and heads of household claim a larger deduction than single filers. As of 2016, the deduction for a single filer was $6,300, while joint filers receive $12,600 and heads of household receive $9,300. These amounts sometimes change, so reference the IRS website for up-to-date information.
Dependents tend to refer to children but include anyone who depends on you. For example, this could be a cousin, niece, step-son or the child of a family friend who you have full custody. Each dependent entitles you to a standard deduction on your taxable income. As of 2016, this amount was $1,050 for each dependent. This amount sometimes changes, so consult the IRS website for updated figures.
Filing status indicates whether you are married, single or have dependents. Married couples can either file jointly or individually, although filing jointly provides extra tax benefits. If you have dependents but aren’t married, then you file as head of household, which also provides tax benefits.
Few things in life as quite as sweet as a tax credit. Deductions are great and all, but they only reduce your taxable income. But tax credits reduce your tax bill, meaning you’ll owe less for the year. Think of tax credits like those coupons people used to clip out of the Sunday paper. Only tax credits are worth much more. The most common example is the Earned Income Tax Credit, or EITC, which aims to help middle and low-income workers. The EITC provides an average of $2,400 to qualifying individuals. Sometimes a tax credit can be larger than the amount you owe, which means you get a nice tax refund. See why they’re so great?
Most people don’t pay a large tax bill all at once like you would for electricity or internet service. That’s because your employer withholds money from your paycheck and keeps it in an IRS account. That way, when it comes time to pay the tax man, you have nothing to worry about. Ever received a tax refund check? That’s the amount of withheld money that exceeds your tax bill. For example:
Your employer withholds $100 from your check each month. At the end of the year, this totals $1200. If your tax bill was $1,000, then you receive a $200 refund.
In many states, such as Arizona, you can choose how much you’d like to withhold for state taxes. In general, the more you choose to withhold, the larger the refund check you’ll receive at the end of tax season.
Hopefully this little primer of tax terms helped you understand what some of this jargon actually means. Be on the lookout for future posts that will help to make doing your taxes a bit less taxing.