Top 10 tax terms you need to know
The new May 17, 2021, tax filing deadline is just around the corner, and that means it is time to start preparing your personal tax return if you haven’t already. To get you started, we explain some of the top tax terms you need to know to be more informed this tax season.
When it comes to taxes, it can seem like you are reading a different language. Learning the lingo can be one of the toughest parts when it comes to filing your taxes correctly and walking away from the experience feeling good. That’s why we’ve compiled the top ten tax terms you need to know to complete your 2020 taxes with confidence.
1. Form 1040
This is the federal income tax return form you’ll use to file your taxes. The form calculates your total taxable income and determines how much you’ll get refunded, or how much you’ll owe the federal government. The Internal Revenue Service (IRS) has two different 1040 forms‡, and the one you fill out depends on your personal situation. Here’s the breakdown:
1040: The standard tax return form; this is what most people file. You report everything on this form, from income to properties owned.
1040-SR: A version of the standard 1040 designed specifically for filers who are older than 65.
2. Adjusted gross income
Your adjusted gross income (AGI) is the amount of money you’ve made throughout the year. Your gross income includes your salary, wages, tips, capital gains, alimony received, interest, and dividends. Once you’ve calculated this initial figure, you need to subtract any adjustments, such as traditional individual retirement account (IRA) contributions, health savings account (HSA) contributions, student loan interest, tuition and fees, or any alimony payments to get your adjusted gross income. Your AGI determines the deductions and credit you are eligible to take.
3. Taxable income
Taxable income is the amount of your income, after deductions, that is subject to income tax. It can consist of both earned and unearned income and is generally less than your gross income. You calculate this by taking your AGI, which is your total income, and subtracting your standard or itemized deductions and qualified business income deduction, if applicable. This final figure is what is used to determine what you owe in taxes.
4. Filing status
Your filing status indicates which tax rates apply to your income and the size of your standard deduction. Filing status is closely linked to marital status and it’s important because marital status and dependents determine a person’s tax bracket. The IRS offers an interactive tool‡ to help you determine your 2020 filing status. There are five different filing statuses:
Married filing jointly
Married filing separately
Head of household
Widow or widower
5. Tax deductions
A deduction is an expense or other amount the IRS allows you to use to reduce the amount of income that is taxed. The rule of thumb is the lower your income, the lower your tax bill will be. Common deductions include traditional IRA contributions, alimony payments and any student loan or mortgage interest you paid.
6. Itemized deduction
To take an itemized deduction, you must keep track of each tax-reducing expense you incur throughout the year. Medical expenses, other taxes such as state, local and property tax, mortgage interest, charitable contributions, casualty and theft losses, and miscellaneous losses such as a significant gambling loss can count as itemized deductions. Each subtracted itemized deduction from your AGI further lowers your taxable income. However, most of the time, you must reach a certain threshold amount beyond the standard deduction and must meet IRS limits to claim itemized deductions. These deductions are also sometimes limited to a percentage of your AGI.
7. Standard deduction
If you choose not to itemize deductions on your tax return, then you will opt to take a standard deduction. This is a fixed dollar amount subtracted from your AGI that reduces the tax amount you’ll owe. Standard deductions are available to every taxpayer and change annually‡. The amount of the deduction can vary depending on your filing status, age and whether you are claimed on someone else’s tax return. For 2020, the standard deduction is $12,400 for individuals, $18,650 for heads of households and $24,800 for married couples who are filing together.
8. Tax credit
Tax credits lower the amount of money you owe to the federal government. Credits are a dollar-for-dollar reduction and directly reduce the amount of tax that you owe, rather than reducing your amount of taxable income. For example, if you claim the earned income tax credit for $1,000 and owe $400 to the IRS, you’ll receive a $600 refund. Child care expenses, paying for higher education and qualifying as low-income can result in getting a tax credit. Claiming all your eligible credits can help boost your refund.
9. Tax scams
Thousands of people have lost millions of dollars and their personal information to tax scams. Scammers use a variety of tools to contact you including mail, phone, or emails. Individuals impersonating IRS officials will ask for personal or financial information and these scams continue year-round. The IRS does not initiate contact with taxpayers by email, text message, or social media. If you are unsure of whether communication you receive is actually from the IRS, you can report it by sending it to email@example.com.
10. Voluntary compliance
Voluntary compliance means everyone is required to pay their taxes by preparing and filing honest and accurate returns. In 2020, if you made more than $12,400, you must file a tax return. If you don’t file, the penalty is 5% of your unpaid taxes each month that your return is late, up to 25%. It’s important to be informed so you aren’t penalized.
A certified public accountant (CPA) can help you stay on top of the deadline and get everything in stress-free, walking you through the steps. If you find yourself needing an extension, the IRS may grant you a six-month extension to file your taxes as long as you complete Form 4868‡, which you can do for free or a low cost.
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