10 Tax Terms You Should Know
The word “taxes” makes most people grimace and we get it: taxes can seem daunting! Even the language around taxes can feel overwhelming. To help combat the confusion, we’re breaking down some popular tax terms and what they mean. Keep reading to learn more!
1. STANDARD DEDUCTION
The fixed dollar amount that the IRS allows you to deduct from your income to reduce your taxable income and therefore your tax liability.
There is a different amount assigned to each filing status (single, married filing joint, married filing separate, head of household). The standard deduction establishes a base deduction that applies to everyone who does not claim itemized deductions, as well as some additional amounts for aged 65 plus, and/or blindness.
The standard deduction is adjusted for inflation each year, and you can determine yours here.
2. ITEMIZED DEDUCTION
A deduction to be subtracted from your income to reduce your tax liability, but only certain expenses are allowed and are subjected to limits (see image below). If you have enough eligible expenses that qualify, itemizing your deductions could result in a lower tax bill than the standard reduction. Remember that itemized deductions will only factor into your return if the sum of those deductions is greater than the standard deduction.
EXAMPLES OF ITEMIZED DEDUCTIONS
Medical and Dental Expenses: unreimbursed medical and dental expenses that exceed a certain percentage of your adjusted gross income (AGI)
State and Local Taxes: State and local income taxes or general sales taxes (you can choose one or the other), real estate taxes, & personal property taxes
Interest Expenses: Home mortgage interest on the first and second homes, points paid on purchasing a home, & mortgage insurance premiums (subject to phase-out)
Charitable Contributions: Donations made to qualifying charitable organizations
Casualty and Theft Losses: Losses from events like natural disasters, fires, or theft, which are subject to certain thresholds
Job Expenses and Certain Miscellaneous Deductions: deductible in the past but were suspended by the Tax Cuts and Jobs Act for tax years 2018 through 2025
Other Miscellaneous Deductions: items like gambling losses (up to the amount of gambling winnings) and federal estate tax on income
3. ALTERNATIVE MINIMUM TAX
The purpose of the Alternative Minimum Tax (AMT)—a separate tax levied by the Federal Government—is that taxpayers pay a minimum amount of tax each year. Most people do not pay AMT since regular income tax is usually the greater of the two taxes.
However, in cases where individuals claim numerous deductions and exemptions, the government may deem a taxpayer's income tax to be too low, thereby triggering AMT.
While AMT has historically applied to high-income taxpayers, inflation and ordinary tax cuts have meant that more individuals find themselves subject to it today. The proliferation of ISOs has also increased the occurrence of AMT. AMT currently has two tax brackets: 26% and 28%.
4. MARGINAL TAX RATE
A progressive method of taxation at which the tax rate increases as income increases. There are different rates at each tax bracket.
As taxable income increases to the next tax bracket, the next tax rate is then charged those additional dollars. Currently, in the US, there are 7 IRS tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The income range for these tax brackets vary depending on filing status.
See 2023's tax brackets here. Let's take a single person for example, the income between $0-$11,000 is taxed at 10%, and then income earned $11,000-$44,725 is taxed at 12%, and so on.
5. EFFECTIVE TAX RATE
The effective tax rate is a helpful metric to truly understand the percentage of your total income you pay in taxes. It differs from your nominal or marginal tax rate, which indicates the rate you pay on the last dollar of your income. Instead, the effective tax rate provides an average rate considering all the tax brackets you fall into. By definition, your effective tax rate is calculated by dividing the total tax you pay by your total income. In simple terms:
Effective Tax Rate (%) = (Total Taxes Paid / Total Income) x 100
For instance, if you earned $100,000 this year and, after considering all deductions, credits, and different tax rates applied to various portions of your income, you paid $15,000 in taxes, your effective tax rate would be 15%.
6. CAPITAL GAINS
Represent the profit realized from the sale of an asset, such as stocks, real estate, or other investments, that has increased in value over time. They are categorized as either short-term or long-term, depending on the duration of asset ownership, and are subject to different tax rates.
7. SHORT-TERM CAPITAL GAIN
Is the profit from the sale of assets that have been held for one year or less. They are taxed as ordinary income, up to a maximum of 37%, depending on tax brackets.
Since long-term capital gains are taxed at a lower rate, investors must consider whether net profits will be increased by holding on to assets for the long term.
8. LONG-TERM CAPITAL GAIN
Is the profit made from the sale of assets, such as stocks or bonds, that have been held for more than one year.
Long-term capital gains are taxed on a graduated scale, up to a maximum of 20%. This tax rate is an important consideration for investors since short-term gains, in contrast, are taxed as ordinary income and this tends to be more costly (a maximum of 37%).
9. TAX CREDIT
A direct reduction to tax that you need to pay. For example, a $500 tax credit would mean that you would pay $500 less in taxes.
10. TAX DEDUCTION
Is a reduction to the total earnings that will be subject to taxation. For example, if an individual with an income of $100,000 receives a tax deduction of $1000, then only $99,000 of their income will be taxed.
As we see, tax deductions only indirectly reduce the amount of tax owed. Therefore, they tend to be less potent than tax credits.
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