Knowing the Jargons
• Adjusted Gross Income
Adjusted gross income, or AGI, is found by subtracting those specific deductions allowed from all the income received during the year. Wages, interest, dividends, business income, income from real estate, pensions and capital gains are examples of income. Deductions can include moving expenses, alimony, IRA deductions, student loan interest, and others. Calculating adjusted gross income is one of the first steps taxpayers take to calculate their final federal income tax bill.
• Alternative Minimum Tax
The alternative minimum tax, or AMT, was created by Congress in 1969 to make sure wealthy taxpayers pay federal taxes even if they qualify for enough deductions to eliminate their federal tax bill. Taxpayers find out if they have to pay higher taxes under the AMT rules, which do not allow taxpayers to use certain tax deductions and credits, by recalculating their taxes using the AMT worksheet. Because the law does not index the exemption to inflation, the AMT has ensnared many middle-income taxpayers in recent years.
Tax credits are the best tax break you can get. They are subtracted from the amount of tax you owe dollar for dollar. If you owe $1,500 in federal taxes and are eligible for a $500 credit, your tax bill is $1,000 after the credit is applied. Tax credits are available for such things as education and energy conservation expenses. Some credits are limited to the tax you owe, but other credits are refundable, meaning you get a refund even if the credit is greater than the tax you owe, and some may be carried forward to be used in future years.
Deductions reduce the amount of income on which tax is due. For example, if a single taxpayer has $35,000 of income and $5,000 in deductions, tax would be paid on just $30,000. Taxpayers often think they have to itemize their deductions using the most complicated tax form. However, any taxpayer can take the standard deduction and other deductions for such things as student loan interest and IRA contributions on a simpler tax form.
• Filing Status
There are five tax filing status categories – single, married filing jointly, married filing separate, head of household, and qualifying widow or widower with a dependent child. Each filing status has its own tax brackets and affects how other tax rules, such as those covering the standard deduction, IRA contribution limits, tax credits and deductions, apply to individual taxpayers.
• Itemized Deductions
These are expenses taxpayers can deduct from their income to reduce the amount of income on which taxes must be paid. To claim itemized deductions, taxpayers must file Form 1040 and detail their deductions on Schedule A. Itemized deductions include medical expenses, other taxes (state, local and property tax), mortgage interest, charitable contributions, casualty and theft losses, and unreimbursed employee expenses. Some itemized deductions must meet IRS limits before they can be claimed.
• Listed Property
Listed property rules were enacted by Congress to prevent abuse of the depreciation rules for property that is used for both business and personal purposes. Listed property definitions include any passenger automobile and computer and related peripheral equipment used partially for business and partially for personal purposes in a trade or business. Such equipment has specific rules that can significantly limit a depreciation deduction or other related expense unless the business use of the property is greater than 50 percent and so long as the taxpayer can properly substantiate the business use.
• Modified Adjusted Gross Income
Modified adjusted gross income (MAGI) is increasingly being used by Congress to limit a tax deduction or credit to individuals below certain income levels. It can create confusion because the term has different meanings depending on the specific tax credit or deduction. Modified adjusted gross income is used in calculating the following tax benefits: the phase out for education loan interest; the income portion of U.S. bonds redeemed for education expenses; adoption tax credits; education tax credits; and in determining the portion of social security benefits taxable as income.
• Personal Exemption
This is an amount taxpayers can subtract from their income to reflect all the people who count on their income. Exemptions can generally be claimed for yourself, your spouse and your dependents. A set amount is allowed for each exemption and helps reduce the amount on which taxes must be paid. The personal exemption amount is taken in addition to any deductions, either standard or itemized, which taxpayers claim.
• Phase-in and Phase-out Limits
These are the dollar thresholds in the tax law at which taxpayers become eligible or ineligible for credits and deductions. Because the phase-ins and phase-outs are not uniform they make the law more complicated.
• Standard Deduction
This is the basic deduction all taxpayers can subtract from their income. It is the most commonly used deduction method because it eliminates the need for taxpayers to itemize actual deductions such as medical expenses, charitable contributions or state and local taxes. The amount of the standard deduction is determined by the taxpayer's filing status, and the amounts change each year because of inflation adjustments.
• Tax Rates
Taxpayers are taxed at one of six different brackets or rates – 10%, 15%, 25%, 28%, 33% and 35%. These rates are the same as last year and are scheduled to remain the same until 2011, when the higher pre-2001 rates will return, unless Congress acts. The income levels for each tax rate may change each year.
• Taxable Income
Taxable income is the amount of income on which tax is paid. It is found by starting with AGI and subtracting an amount that corresponds to the number of personal exemptions allowed, and either the total amount of allowable itemized deductions or the standard deduction.
The amount of money an employer withholds from an employee’s paycheck to pay federal, state or local taxes on the amount the employee earned. Taxpayers are credited for the amount of tax dollars withheld when they file their tax returns. In some cases, taxes may be withheld from other income such as dividends and interest.