It seems that the older we get, the more complicated our taxes become. As our financial portfolio grows, so does our tax responsibilities. It’s difficult to remember all of the terms and what they each mean. Let’s take a look.
Adjusted Gross Income
Often called AGI, adjusted gross income is the total income that you’ve received throughout the year. This includes your wages, any interest accrued, capital gains, and dividends. The reason it’s called “adjusted” is because it also takes into account the deductions throughout the year. Any contributions made to an IRA, certain business expenses, alimony payments, and even moving costs. The AGI is your income minus the specific reductions and is the first place to start when determining your income tax.
Standard Deduction
A standard deduction is determined by your filing status and is available to all tax filers. It’s a fluctuating amount, year by year, based on inflation. This is the fixed amount that tax filers may deduct from their income. A standard deduction allows taxpayers to eliminate the need for itemizing actual deductions like medical, charitable, and state taxes. This is the most popular deduction method for tax filers.
Itemized Deductions
While a standard deduction is a specific dollar amount that fluctuates with inflation, itemized deductions allow taxpayers to deduct expenses from the AGI. This allows you to have a smaller income total when you calculate your annual taxes. Deductions must meet IRS limits before being claimed but include things like mortgage interest, gambling losses, charitable donations, other taxes, medical expenses, and losses from theft. Tax filers must prepare a Form 1040 and list the deductions on Schedule A.
Withholding
If you’ve filled out a W2 form, you might have seen the term withholding. This is often called pay-as-you-earn taxes. Rather than wait to pay the whole tax bill at the end of the year, this allows taxes to be taken from the wages prior to receiving a paycheck. The funds are placed into an IRS account and credited when you file your tax return at the end of the year.
Exemption
The IRS allows you to claim tax exemptions. This includes you, any dependents, and your spouse. Similar to a standard deduction, the IRS sets an amount for each of the exemptions that you subtract from your AGI to give you a lower income amount to file taxes. This is in addition to the standard or itemized deductions that you claim.
Taxable Income
The total, or gross, income, once you’ve adjusted for all deductions and exemptions, is your taxable income. This is the final dollar amount of income that is used to figure out what you owe in taxes for the year.
Tax Credits
Once you’ve calculated your tax bill, tax credits allow you to reduce what you owe to the IRS. Considered more valuable than deductions because they reduce the amount of tax owed. If you had a tax bill of $800 but qualified for $1000 in tax credits, you would end up with a refund.
Tax Deductions
The IRS allows tax filers to deduct expenses from the AGI to find the total taxable income. If you have a lower income, the tax bill should be lower, making this a beneficial tool for tax preparers. Two of the most popular deductions are the standard deduction offered by the IRS which is a fixed amount. The other popular deduction option is itemized deductions which allow you to get more specific with your deductions.
Voluntary Compliance
This is the system that keeps our economy honest. The IRS is a beast of an organization and even still it’s difficult to police every single taxpayer in the country. Voluntary compliance is the system in which taxpayers honestly report their income and tax burden to the IRS.
Progressive Taxation
The lower your income, the less you pay in taxes; the higher your income, the more you pay in taxes–this is the idea behind progressive taxation. You might have heard the term, tax brackets. The United States uses progressive tax brackets that start at 10% and rise to near 40% for the wealthiest of taxpayers.
Defined Contributions
The most popular type of retirement plan is a defined contribution plan. These include contributions made by yourself and your employer if you’re lucky enough. The account value will vary depending on performance. You’ll recognize defined contribution plans by their names 401(k), 403(b), profit sharing, and stock ownership programs. These fall into the AGI.
Defined Benefits
Less popular than defined contribution plans are defined benefits plans. Also a form of retirement plan, you’ll typically hear these called pension plans. More popular a few decades ago but still available depending on industry and company. It’s a guaranteed monthly benefit that you receive at retirement, usually based on salary or age.
Dependent
The IRS allows you to claim dependents on your tax forms. This is a person, other than yourself or spouse, in which you can claim as an exemption. Typically, this is a child or older relative for whom you provide full care.
Filing Status
Your relationship status determines how you are going to file your taxes and any tax breaks that you may be entitled. The most popular filing statuses are “Single”, “Married Filing Jointly”, and “Married Filing Separately.” The IRS offers a great resource to figure out the correct status for you.
Capital Gains
A capital gain is a profit that you’ve received from ridding your portfolio of an asset. These are things like selling stocks or real estate. A capital gains tax is a 15% tax incurred on these sales or 20% for wealthier individuals.
Learning tax terms doesn’t have to be difficult. The more prepared we are with what things are, the easier our taxes become. Understanding the complex world of taxation allows us to take control over our financial independence.
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