One of the hardest things about taxes is learning the language. You’ve got all the forms and instructions, but it seems they’re harder to decipher than your VCR user manual.
Here are 10 common tax terms to help you start talking taxes.
1. AGI — Adjusted gross income, or AGI, is all the income you receive over the course of the year such as wages, interest, dividends and capital gains minus items, such as contributions to a qualified IRA, some business expenses, moving costs and alimony payments. The adjusted gross income is the first step in calculating your final federal income tax bill.
2. Credits — Tax credits are much like credits you get from a store. After you calculate your tax bill, you can use the credit to reduce the amount of the check you must write to Uncle Sam. 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 $200 credit, for example, will turn a $1,000 tax bill into only $800. A few could even give you a refund you weren’t expecting.
3. Deductions — Deductions are expenses that the Internal Revenue Service allows you to subtract from your AGI to arrive at your taxable income. In most cases, the lower your income, the lower your tax bill. If, for example, a single filer has income of $38,000 and $8,000 in deductions, then he would pay taxes only on $30,000. The IRS offers all filers a standard deduction amount (more on this later). Some other deductions, such as student loan interest, moving expenses, deductible IRA contributions and alimony payments, are also listed directly on Form 1040A or long Form 1040. The term is most commonly associated with the itemized deductions (more on this later, too) that are claimed by taxpayers who file Schedule A.
4. Standard deduction — This is a fixed dollar amount that a taxpayer can subtract from his or her income. The standard deduction is available to all filers and is determined by the taxpayer’s filing status. The amounts change each year because of inflation adjustments; you can find the current standard deduction levels listed on each of the three individual tax forms. This deduction method is used by most taxpayers and eliminates the need for them to itemize actual deductions such as medical expenses, charitable contributions or state and local taxes.
5. Itemized deductions — These are expenses that can be deducted from your AGI to help you reach a smaller income amount upon which you must calculate your tax bill. Itemized deductions include medical expenses, other taxes (state, local and property tax), mortgage interest, charitable contributions, casualty and theft losses, unreimbursed employee expenses and miscellaneous deductions, such as gambling losses. Some itemized deductions must meet IRS limits before they can be claimed. When you itemize, you must file Form 1040 and detail your deductions on Schedule A.
6. Exemption — This is an amount that the IRS lets you subtract from your income to reflect all the people who count on your income. Exemptions can be claimed for yourself, your spouse and your dependents. The IRS allows a set amount for each exemption and, as with deductions, this total is subtracted from your adjusted gross income to come up with your final, lower earnings amount upon which you must figure your tax bill. Your personal exemption amount is in addition to any deductions, either standard or itemized, that you claim.
7. Progressive taxation — This is the system in which higher tax rates are applied as income levels increase. The U.S. tax system uses progressive taxation with tax brackets starting at 10 percent and rising to 35 percent for the wealthiest taxpayers.
8. Taxable income — Your overall, or gross, income reduced by all allowable adjustments, deductions and exemptions. It is the final amount of income you use to figure just how much tax you owe.
9. Voluntary compliance — This describes the philosophy upon which our tax system is based: that U.S. taxpayers voluntarily comply with the tax laws and report their income and other tax items honestly.
10. Withholding — Also known as pay-as-you-earn taxation, this method enables taxes to be taken out of your wages or other income as you earn it and before you receive your paycheck. These withheld taxes are deposited in an IRS account and you are credited for the amount when you file your return. In some cases, taxes also may be withheld from other income such as dividends and interest.
For a complete list of tax terms, check out our tax glossary.