Taxes for Beginners: Top 10 Must-Know Terms

tax-timeHere we are again: another year, another tax season. While filing your taxes will probably never be fun—if you know how to make this possible, I’d love to hear!—at least you can make it easy by heading into battle with an armory of tax knowledge. Don’t let something as trivial as tax jargon confuse you into making a mistake on your forms. Below you will find a condensed glossary of our top 10 must-know tax terms, so that you don’t have to pull out a dictionary for every unfamiliar word you find as you prepare your income tax return. Good luck and happy filing!

1.) Adjusted Gross Income (AGI)

Your or your family’s wages, salaries, interest, dividends, capital gains etc., minus allowable deductions (ex. contributions to a qualified IRA, student loan interest payments, some business expenses, moving costs and alimony payments) as reported on a federal tax return.

2.) Credits

After you figure your tax bill, you can use credits to reduce your final tax bill. Tax credits are more valuable than deductions because they directly cut the amount of tax you owe, rather than reducing the amount of taxed income. A $400 credit, for example, will turn a $1,000 tax bill into only $600. And a few even could give you a refund you weren’t expecting. Credits are allowed for such purposes as child care expenses, higher education costs, qualifying children, and earned income of low-income taxpayers.

3.) Deductions

Deductions are expenses that are subtracted from your AGI to determine your taxable income. If, for example, a single filer has income of $35,000 and $5,000 in deductions, then he would pay taxes only on $30,000. They include deductions for student loan interest, moving expenses, alimony paid, a penalty on early withdrawal of savings, and contributions to an individual retirement arrangement (IRA). Adjustments to income can be taken even if itemized deductions are not claimed.

4.) Exemption

An exemption is the amount that taxpayers can claim for themselves, their spouses, and eligible dependents. Your personal exemption amount is in addition to any tax deductions, either standard or itemized, that you claim. The total is subtracted from adjusted gross income before tax is figured on the remaining income (taxable income).

Tax exemptions come in many forms, but one thing they all have in common is they either reduce or entirely eliminate your obligation to pay tax. Most taxpayers are entitled to an exemption on their tax return that reduces your tax bill in the same way a deduction does. Federal and state governments frequently exempt organizations from income tax entirely when it serves the public, such as with charities and religious organizations.

5.) Itemized deductions

eductions are subtracted from adjusted gross income to help you reach a smaller income amount in figuring taxable income. The deductions allowed on Schedule A (Form 1040) are for medical and dental expenses, taxes, home mortgage interest and investment interest, charitable contributions, unreimbursed employee expenses, casualty and theft losses, and miscellaneous deductions.  Itemized deductions cannot be claimed if the standard deduction is chosen.

6.) Progressive taxation

A tax that takes a larger percentage from the income of high-income earners than it does from low-income individuals. Essentially, individuals who earn more money pay higher taxes; those taxes are then used to fund social welfare programs that are used primarily by individuals who earn less.

The United States income tax is considered progressive: in 2010, individuals who earned up to $8,375 fell into the 10% tax bracket, while individuals earning $373,650 or more fell into the 35% tax bracket. Basically, taxpayers are broken down into categories based on taxable income; the more one earns, the more taxes they will have to pay once they cross the benchmark cut-off points between the different tax bracket levels. (Source: www.investopedia.com)

7.) Standard deduction

This is a fixed dollar amount deduction that reduces the amount of income on which you are taxed based on your filing status. You cannot take the standard deduction if you claim itemized deductions. Your standard deduction consists of the basic standard deduction amount based on your filing status and additional standard deduction amounts for age and blindness. Taxpayers with certain large expenses such as medical expenses, charitable contributions, mortgage interest, property taxes and state and local taxes and who can prove those expenses might choose to itemize their deductions if it adds up to more than the standard deduction. The fixed dollar amount for standard deductions changes every year; current levels are found on your individual tax forms.

8.) Taxable income

This is your gross income minus any adjustments to income, any allowable exemptions, and either itemized deductions or the standard deduction. It is the final amount of income you use to calculate how much you owe in taxes.

9.) Voluntary compliance

The income tax system is voluntary. That’s because people are free to arrange their financial affairs in such a way to take advantage of any tax benefits. Voluntary does not mean that the tax laws don’t apply to you. Voluntary means you can minimize your taxes by taking advantage of various deductions and tax credits. “A system of compliance that relies on individual citizens to report their income freely and voluntarily, calculate their tax liability correctly, and file a tax return on time,” according to the Internal Revenue Service. (Source: http://taxes.about.com)

10.) Withholding tax

This is money that employers withhold from employees’ paychecks. This money is deposited for the government. (It will be credited against the employees’ tax liability when they file their returns.) Employers withhold money for federal income taxes, federal social security taxes, and state and local income taxes in some states and localities. In some cases, taxes also may be withheld from other income such as dividends and interest. (If you are your own boss this does not apply to you. Income tax for the self-employed is handled differently.)

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