Tax Terminology

by | Jun 22, 2020

How to Do Your Taxes

Working Title: A Guide to Tax Terminology

Don’t know the difference between a W-2 and a W-4? Grabbed a 1099 when you meant to grab a 1040? Don’t worry, we’ve got your back! Taxes are stressful enough without all the complicated jargon attached. Whether you’ve never filed taxes before or are a seasoned veteran, our Guide to Tax Terminology is here to help you navigate tax season with ease!

IRS Tax Forms

Form 1040 is the centerpiece of your tax returns. It helps you calculate your taxable income, claim tax deductions or use tax credits, and determine the final amount you owe. A separate Form 1040-SR document also exists for people age 65 and older. However, most citizens will also need to fill out additional tax form attachments.

Common Attachments allow you to report additional earnings or deductions.

  • Schedule A documents itemizing deductions such as mortgage interest or charitable donations.
  • Schedule B reports any interest or dividends exceeding $1500 in taxable accounts.
  • Schedule C records any profits or losses for a business you own
  • Schedule D reports capital gains or losses from stocks.
  • Schedule SE helps calculate your tax if you are self-employed.

These attachments are the ones most commonly used, but you should also check the IRS’s website to see if any others may apply to you.

Finally, there are several popular forms that can document your income and make your life easier come tax time.

W-4 forms are filled out by employees to indicate their tax situation to their employer. The W-4 form tells the employer how much tax to withhold from an employee’s paycheck for taxes.

Form W-2 is issued by your employer and records your earnings for the year.

Form 1099 reports income not coming from wages or tips, such as interest earned on savings and investments.

These resources will provide useful information when filling out your Form 1040. If all this is scaring you or went over your head, don’t worry. There are plenty of tools online that will help you fill out your taxes. And if you ever forget a definition or need a refresher, our guide will always be here to help.

Income

Gross income is the total income you earn before paying taxes or deductions. That is, it’s the starting point from which your tax liability is calculated. This includes earned income from wages or salary as well as unearned income, such as interest on investments.

Taxable income is the income for which you actually have to pay income taxes. This is not the same as your gross income, because not all income is taxable (e.g., interest earned from some types of bonds), and some of your gross income is subtracted as deductions.

Net income is the money you take home after accounting for taxes. It can be noted as (taxable income) – (income taxes) + (deductions).

Emma’s gross income is $10,000 per month. From that she can deduct $2,000 (money she won’t pay taxes for). Therefore, she pays taxes on the remaining $8,000 (her taxable income), and her taxes turn out to be $3,000. This means she has $5,000 left after tax + the $2,000 she deducted. Therefore, her net income is $7,000 per month.

Tax Deductions

A tax deduction is a reduction in taxable income. That is, tax deductions reduce the amount of income that is subject to federal income tax. A bigger deduction means you pay less in taxes. Taxpayers have the option to take a standard deduction or to itemize deductions.

The standard deduction is a fixed dollar amount that you can subtract from your taxable income. Even if you have no tax-deductible expenses, you can take the standard deduction. In 2019, the standard deduction was $12,200.

If you choose to itemize deductions, you must add up your deductible expenses to determine the total size of your deduction. You should only itemize if the total amount of your itemized deductions is more than the standard deduction amount.

A deductible expense is an expense that you can subtract from your taxable income if you choose to itemize. A non-deductible expense, on the other hand, does not change your taxable income. Examples of deductible expenses include home mortgage interest, medical expenses, and charitable donations. Most expenses, such as food or rent, are non-deductible.

Payroll Deductions

Keep in mind that tax deductions are different from payroll deductions.

A payroll deduction is an amount of money withheld from an employee’s payroll check. Payroll deductions may be mandatory or voluntary.

Mandatory payroll deductions are required by law. Mandatory deductions INCLUDE federal, state and local income tax, and Social Security and Medicare taxes.

Voluntary payroll deductions are the ones the employee can choose and control. Voluntary deductions cannot be withheld from an employee’s payroll check unless the employee agrees to the deduction. Some examples of voluntary payroll deductions include health, life, and disability insurance, retirement account contributions, and other job-related expenses.

Payroll deductions decrease your take-home pay. Take-home pay is the net amount of income you receive, or the amount of money you actually get to keep. It is your income minus all of your deductions.

Many payroll deductions reduce your taxable income, but some do not. If you are unsure whether or not your payroll deductions are taxable, contact your HR department.

Other Common Deductions

Wage garnishment is a mandatory, involuntary payroll deduction that is usually a result of a court order. It allows the plaintiff to deduct money from the defendant’s salary to pay off a debt owed to the plaintiff.

Child care is an example of a voluntary deduction you can make in your payroll. For example, a company might offer you the option of using payroll deductions to create a Dependent Care Flexible Spending Account. Through this account, the IRS allows parents to contribute up to $5,000 tax-free per year to childcare accounts for expenses on dependents.

Union dues are fees that employees pay to obtain membership in a union. Companies may offer employees a voluntary payroll deduction to cover these fees.

Charitable contributions are another form of voluntary payroll deduction. Employees may elect to donate the allotted income to charitable causes, such as the Red Cross or Habitat for Humanity.

Commuter benefits are often offered by employers as a voluntary payroll deduction to reduce parking and public transportation commuting costs. This way, the employee’s commuting costs are taken out of their paycheck and are not taxed.

Tax Rates

Once you have determined your deductible expenses, you are ready to find your tax rate.

A tax rate is the percentage at which an individual or company is taxed. For example, if Emily earns $120,000 per year and pays 20% of that in taxes, the tax rate is 20%.

A tax bracket is a range of incomes which are taxed at a certain income tax rate. For example, in 2018, income from $38,701 to $82,500 was taxed at 22%. The differences in the percentages between different tax brackets are called marginal increments.

The U.S. has different tax brackets because we use a progressive tax system. A progressive tax system means that the tax rate increases with every new tax bracket. The first bracket $0 to $9,525 is taxed at 10%, while the last bracket $500,001 or more is taxed at 37%. Therefore, in a progressive tax system, your marginal tax rate will always be larger than your effective tax rate (an average of all the tax rates you’ve been taxed at).

Your marginal tax rate is the tax rate you pay on your last dollars of income. For example, if John earned $55,000 in 2018, he falls into the $38,701 to $82,500 tax bracket, meaning that his marginal tax rate would be 22%. However, because of the progressive tax system, even though John falls in the 22% bracket, not all of his income is taxed at 22%.

Your effective tax rate is the actual percentage of your annual income that you owe. For John, since he earned $55,000 and paid $8,040 in federal income taxes, his effective tax rate would be 14.6%: ($8,040 / $55,000) * 100). Note that this is lower than his marginal tax rate.

Tax Credits

After you have determined your taxable income and tax rate, you can determine if you qualify for any tax credits.

A tax credit is an amount of money that taxpayers can subtract from taxes owed to the government. Unlike deductions, which reduce the amount of taxable income, tax credits reduce the actual amount of taxes you owe.

Governments may grant tax credits to promote certain behaviors. For example, a person might get a tax credit for updating their washing machine to a more environmentally friendly machine that uses less water.

There are two types of tax credits, nonrefundable and refundable.

A nonrefundable tax credit means you get a refund only up to the amount you owe. Any amount greater than the tax owed is not paid out. So if you owed $100 and your credit was for $150, you would owe $0 but would not get refunded the $50.

A refundable tax credit means you get the entire credit, even if it’s more than what you owe. So if you owed $100 and your credit was for $150, you would get a refund for $50.

Common tax credits:

  • The Earned Income Tax Credit (EITC) is for low- and middle-income taxpayers and provides an incentive for people to work.
  • The Child Tax Credit is for people with dependents under the age of 17.
  • The American Opportunity Tax Credit applies to college fees and allows a credit for tuition, enrollment fees and course materials.

Tax Refunds

After adjusting for your deductions and tax credits, you may find that you did not need to pay as much in taxes as you initially thought. In this case, you may qualify for a tax refund.

A tax refund is the difference between taxes paid and taxes owed. A taxpayer will get a tax refund if she has overpaid taxes to the government.

Every year, taxpayers submit tax returns that calculate how much they owe in income taxes. The IRS then reviews the information. If a taxpayer has paid more taxes than she owes, the IRS will issue her a refund.

W-4 forms are filled out by employees to indicate their tax situation to their employer. The W-4 form tells the employer how much tax to withhold from an employee’s paycheck for taxes.

W-4 forms are used to calculate an employee’s withholding allowances. A withholding allowance is a reduction in the amount of income tax an employer withholds from an employee’s paycheck. The more allowances you claim, the less income tax will be taken from your paycheck.

The number of allowances you can claim depends on your income, marital status, number of dependents, and number of jobs. If you don’t claim enough, you will overpay your taxes and end up with a tax refund at the end of the year. If you claim too many, you will owe the IRS money and may have to pay a penalty.

Whew! That was a lot. We know tax terminology can be confusing, but if you take it one step at a time, tax season will be over before you know it.

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