Top 10 Tax Terms to Know Before You File

Top 10 Tax Terms to Know Before You File

Whether you are preparing your own taxes or hiring a tax professional, understanding the tax language will help you minimize your tax liability. With all the forms and constantly changing tax code, understanding what key terms mean will help you navigate the world of taxes.

With an increasing number of companies offering online tax filing and step-by-step guides, more Americans are gaining confidence in their ability to file their own taxes. Key tax terms are used not only during tax time, but also on loan applications and other times when income verification is required.

10 Key Tax Terms You Need to Know Include the Following:

  • Filing Status determines your tax rate and is established by your household. Single parents or those with adult dependents may file as head of household. Married couples have the option of filing jointly or separately. Filing status options include:
    1. Single
    2. Married filing jointly
    3. Married filing separately
    4. Head of Household
    5. Qualifying Widow(er) with dependent child
  • Taxable Income is the final amount of income you will be taxed on after all deductions and exemptions are taken. Not all income or gains are taxable and some payments you might not expect to pay taxes on are taxable. Examples of taxable income include wages reported on a W-2, taxable interest or gains from investments, business income, some IRA distributions, unemployment, alimony, jury duty, and gambling winnings. Examples of nontaxable income might include child support payments, gifts, welfare benefits, and personal injury jury awards. Other forms of income that may or may not be taxable include Social Security benefits, any life insurance proceeds, scholarships, and some investments that have tax preferred features or are held in retirement accounts.
  • AGI or Adjusted Gross Income is the most common figure used on applications when establishing the income of an applicant. On the 1040 tax form, the AGI is listed as line item 37. Your AGI constitutes total income minus a number of deductions that can be taken without having to itemize. A few of the most popular deductions that reduce taxable income include educator expenses for teachers, self-employment tax for business owners, freelancers and those receiving a 1099, IRA deductions for retirement contributions, and student loan interest payments. For tax purposes these items directly reduce your total income.
  • Tax Deductions can be taken by both individuals and businesses. Many small businesses report earnings on personal tax returns. These include sole proprietors, S Corporations and LLCs. The IRS rules allow for certain costs and expenses to be deductible from income. These deductions can be taken off at the front end and reduce the total income that establishes the AGI or on the back end through itemized deductions. Business deductions reduce business taxable income. Tax filers have the option to choose whether to accept the standard deduction or itemized deductions, depending on which option will give you the greater benefit.
  • Itemized Deductions are subtracted from the AGI to reduce taxable income. In order to take itemized deductions, they will need to be greater than the standard deduction. Homeowners with high interest payments, those who give generously to charities, high medical bills, or having a lot of unreimbursed business expenses, can result in itemize deductions reducing tax liability beyond the standard deduction offered. These deductions are taken on the Schedule A, which requires a separate form. Is estimated that roughly 1/3 of taxpayers itemize.
  • Standard Deduction is offered to all taxpayers and does not require itemization. The standard deduction is taken based on your age, your filing status, and the number of dependents or exemptions you are able to claim and provides a fixed dollar amount that reduces your AGI before establishing taxable income. When itemized deductions do not create a lower income, the standard deduction is used. Taking the standard deduction saves time and eliminates the need to maintain receipts and other proof of expenditures that occurred throughout the year, and is used by the majority of tax filers. For example, a single filer under 65, the deduction is $6,300. A couple who is married filing jointly, have a standard deduction of $12,600. This increases to $15,100 for a couple over 65.
  • Tax Credits offer a number of circumstances where you can directly reduce your tax bill. These are very valuable because they reduce tax liability rather than income. Even if you do not owe any taxes, some tax credits can result in payments in the form of a refund. Commonly used tax credits include earned income credit (EIC) for low to moderate income families, educational credits, child care credits, and savings contributions credits.
  • Tax Exemptions include the number of people you are given credit for supporting. The number of tax exemptions help establish the standard deduction for your family along with the personal exceptions that are accompanied by the number of dependent exemptions you are able to claim. Both standard deductions and exemptions reduce your AGI, before your taxable income is determined.
  • Progressive Taxation System is the tax system we operate on. This means the tax rate increases based on the income of the taxpayer. Income tax rates begin as low as 10% and cap out at 39.6%. Those with income below the personal exemption and standard deduction are not required to file taxes. This tax system also taxes income at different rates, even for the same taxpayer. For example, if you are single and have a taxable income of $100,000 you are in the 28% tax bracket. However, you will not pay 28% on all your income. You pay 10% on the first $9,225, and 15% on the amount between $9,226 and $37,450. You are then taxed at a rate of 25% for the income between $37,451 and $90,750. Only amounts above $90,750 are taxed at the 28% rate.
  • Withholdings are claimed on the W-4 and filed with your employer and are based on the number of exemptions or allowances you take. The number of allowances establish the withholdings that are taken from your paycheck each pay period. The idea is to pay a little in taxes as the year goes by, eliminating or reducing tax liability when taxes are filed based on your anticipated tax bill. If you receive a refund the following April, you can change your withholdings to a higher number and receive a larger paycheck.

The tax language can create confusion when you don’t understand the meaning of commonly used tax terms. Arming yourself with this information will enable you to make informed decisions when it comes to paying taxes.  And, if you don’t understand something, always ask.

Filing your taxes correctly and recognizing every deduction that is available to you will help you maximize any refunds owed to you.  Windfalls from tax refunds are a great tool to help you reduce debt.  For a FREE debt analysis, contact one of the specialists at Finance Solutions today.