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What the What? 10 Tax Terms Decoded

Feb 02, 2021 3 min read Rebecca Lake

Key takeaways

  • Making sense of key tax terms can result in more dollars when you file.
  • Deductions cut your taxable income; credits come off your tax bill, dollar for dollar.
  • The new math: W-4 comes before W-2.

 

Do you have a love/hate relationship with tax season? As in, you love the idea of possibly getting a refund, but you hate the hassle of organizing receipts and filling out endless forms, all while trying to decode IRS jargon?

 

 

Unfortunately, no one has invented a kindly deduction-finding-tax-filing robot (Hello Silicon Valley, anyone listening?), but this go-to guide can ease your angst by breaking down 10 of the most common tax terms.

 

  1. 1. Deduction

    A deduction is money you can subtract from your taxable income, which is the amount of money you earned that you pay taxes on each year.

    Deductions can be standard or itemized. The standard deduction is a flat amount you subtract from your taxable income. Itemized deductions are specific expenses, like interest paid on your mortgage or charitable donations, that the government has deemed tax-deductible.

    Itemizing is a little more complicated, but it can yield a bigger tax break if the amount you're deducting is more than the standard deduction.

     

  2. 2. Tax credit

    Tax credits shrink the amount of tax you owe. Say you owe $5,000 in taxes, and you qualify for a credit worth $1,500. That credit gets applied to the $5,000, bringing down what you owe to $3,500.

    Some credits are refundable, meaning you can claim the credit even if it's more than what you owe. The difference gets added onto your refund. Others are nonrefundable, which means you can only claim them up to the amount of tax you owe.

    Three commonly claimed credits:

    Being able to claim a particular tax credit may hinge on your income, filing status and whether anyone else can claim you as a dependent. (More on what those last two terms mean in a minute.)

     

  3. 3. Filing status

    There are five different statuses you can choose from to file your federal taxes:

    • Single
    • Married, filing jointly
    • Married, filing separately
    • Head of household
    • Qualified widow(er) with a dependent child

    Your filing status determines the size of the standard deduction you're able to claim. It also affects your ability to claim certain itemized deductions or credits.

     

  4. 4. Tax Bracket

    A tax bracket is an income range that is taxed at a certain rate. There are seven tax brackets. The one you fall into depends on your filing status and taxable income. (That's where deductions come in handy—being eligible for more deductions can push you into a lower tax bracket, which would lower your tax bill.)

     

  5. 5. Adjusted gross income (AGI)

    Gross income is all the money you take in from working, selling a home or other investments for a profit, gambling winnings or gifts. Adjusted gross income (AGI) is what's left after you factor in certain tax adjustments, such as contributions to a retirement account and student loan interest you paid.

    Your AGI matters because it determines two things: how much tax you'll owe and whether you qualify to claim certain tax credits or deductions.

     

  6. 6. Dependent

    A dependent can be a child, an aging parent or another relative who lives with you and who relies on you for financial support. You used to be able to claim dependents on your taxes to get an exemption. An exemption is an amount subtracted from your adjusted gross income. (Personal exemptions were eliminated by federal law, but you get a tax credit in the amount of $2,000 for a dependent child under age 17 and $500 for other dependents.)

     

  7. 7. Form 1040

    Form 1040   PDF opens in new windowis an official form you use to file your federal taxes. Anyone can file a Form 1040, and you're required to file it if you're claiming business or self-employment income.

    If your taxable income is less than $100,000 and you're not itemizing, you can file Form 1040EZ or Form 1040A instead. Form 1040A gives you the option to claim certain credits, including the Child Tax Credit and the credit for child and dependent care.

     

  8. 8. W-2 and W-4

    A W-2 is a tax form your employer sends out, usually around the end of January. It shows how much money you made and how much you paid in taxes in the previous year. A W-4 is the form you submit when you're hired (or change afterward) that tells your employer how much to withhold in taxes from each paycheck.

    If you withhold too much in taxes, you get a refund; if you withhold too little, you run the risk of owing taxes and underpayment tax penalties in April (extended to May for 2020 federal taxes). It's a good idea to assess your withholding and update your W-4 once a year. Ideally, you pay the appropriate amount of taxes so that you don't owe money or get too big a refund when you file.

     

  9. 9. Alternative minimum tax (AMT)

    The alternative minimum tax might kick in if you earn a higher income but won't be paying enough in taxes. It requires you to figure out your tax liability (or how much you owe in taxes) using regular income tax rules and AMT rules. You pay whichever one results in a higher tax. It doesn't exactly sound fair, but it's meant to keep taxpayers in higher tax brackets from taking advantage of loopholes. The exemption for calculating AMT has been substantially increased, so fewer people are subject to the tax.

     

  10. 10. Loophole

    A loophole is a way to (legally) reduce the amount of taxes you owe because of a gap in the tax code. Some loopholes, like refundable credits, tend to benefit lower-income taxpayers. Others, like the mortgage interest deduction, often benefit taxpayers in higher tax brackets.

 

What you can do next

Learn the tax lingo that applies to you so you can better understand and take advantage of tax laws. Of course, you should consult your tax and legal advisors for advice concerning your particular circumstances.

Footnotes

Rebecca Lake has been covering finance, investing and small business for nearly a decade. Her work has appeared online at U.S. News & World Report, MSN Money, Business Insider and Investopedia.

 

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