Isn’t it strange that despite the running joke about the certainty of tax (akin to death), most of us don’t know many of the terms come tax time? We really think that this is the sort of stuff we ought to be taught in schools. There are numerous tax terms that we ought to understand as it could prove handy in keeping some money in our pockets. As the tax season comes to an end this year, in this post, we will try and explain some of the tax terms that are thrown about so come next year, you are ready to handle business. So lets get right into it.
What’s a Deduction?
Simply put, this is money that you can subtract from your taxable income. In other words, its the money that you earned which you pay taxes on every year. Deductions can either be itemized or standardized. A standard deduction is a flat rate/amount that you subtract from your taxable income. Whereas an itemized deduction are specific. Things like mortgage interest, donations and other things make up this list. Though the latter strategy requires a bit more work, it can result in a bigger tax break for you if the amount you are deducting is greater than what the standard deduction would be.
What are Tax Credits?
Tax Credits are tax breaks that allow you to reduce the amount of money owed to the IRS. For instance if you owe $3,000 in taxes and you got a tax credit for $1,500, you will end up owing only half of the $3,000. Credits can also be refundable which means that you can actually have a higher credit amount than what you owe in which case you end up getting a refund. On the other hand, credits which are non-refundable can only be applied towards the maximum of what you owe in taxes. You end up forfeiting the rest.
There are various types of tax credits. The most common ones are: Child Tax Credit, Earner Income Credit and Retirement Saver’s Credit. Qualifying for tax credits depends on factors such as your filing status, income and whether you can claim dependents.
Filing Status
There are 5 different filing statuses associated with Federal tax filing. 1. Single. 2. Married, filing jointly. 3. Married, filing separately. 4. Head of Household. 5. Qualified widow(er) with a dependent.
Filing status is what helps determines the size of the standard deduction (discussed earlier) that you are able to claim. It also impacts on which itemized deductions and credits you can qualify for.
What is a Tax Bracket?
The income range that is taxed at a specified rate is called a tax bracket. The IRS has set up 7 tax brackets. The one you fall into depends on your taxable income and the filing status. You can utilize tax deductions to lower your tax bracket which in turn can help bring your tax bill lower.
What’s Adjusted Gross Income?
Gross income is everything that you make or take home from your job, sale of a property or other investments for a gain, winnings (gambling and such) or gifts. Adjusted Gross Income is what is left after certain tax adjustments such as retirement plan contributions etc, are accounted for. Adjusted Gross Income determines the taxes that you will wow and if you will be able to claim certain tax credits.
Dependents
Any child, aging parent or another relative who lives with you and depends on you financially qualify as your dependent. In the past, you used to be able to claim dependents as exemptions on your taxes. Now you get a tax credit in the amount of $2,000 for dependent children under than age of 17 and $500 for other dependents.
What are W-2 and W-4 forms?
W-2 forms are sent out by you employer around January time frame. It shows how much money you earned and how much you paid in taxes in the previous year. A W-4 is a form that you submit to your employer upon getting hired to tell your employer how much to withhold in taxes from each paycheck.
You get a tax return if you withhold too much and you run the risk of owing taxes if you withhold too little. It’s good to assess your withholding and update your W-4 once a year. Ideally the amount should be appropriate such that you don’t owe or receive too much.
What is Form 1040?
This is the official form that you fill out to file your federal taxes. If you are claiming business or self employment income, than you must file this form. If your taxable income is less than $100,000 and you are not itemizing your deductions, you can file a 1040 EZ or 1040A form instead depending on whether you are claiming child care or dependent care credits or not.
What is Alternative Minimum Tax (AMT)?
AMT comes into effect when you earn a high income but won’t be paying enough taxes. This will require you to figure out how much taxes you owe using regular income tax rules and AMT rules. You pay whichever one results in the higher tax amount. Though it may not sound fair, its meant make tax payers earning higher income from taking advantage of any loopholes.
What is a Loophole?
If there is a way to legally reduce the amount of taxes you owe because of a gap in the tax code is called a loophole. Loopholes such as refundable credits can sometimes help low-income tax payers. Others such as mortgage income deduction can benefit higher income tax payers.
Conclusion
Now that you know the above ten tax related terms, we hope that it will help you figure out which terms apply to you allowing you take advantage of the tax laws. You should of course consult your tax and legal advisors concerning your individual circumstances but it’s helpful to understand the tax terms.