Confused by tax terminology? Don't fret! We've broken down some commonly used tax terms to help you learn the lingo.
A tax liability, also known as a tax obligation, is the total amount of tax debt owed by an individual, business, or other taxable entity (such as a trust).
An individual’s filing status plays an important role in determining his or her tax liability. It also affects taxpayers’ eligibility for certain tax credits and the size of one’s standard deduction. Tax filing status is largely determined by one’s marital status. In a given tax year, individuals are considered married for tax purposes if they are married as of December 31st of that year.
There are five different filing statuses:
Single: This filing status is for taxpayers who are unmarried or divorced.
Married Filing Jointly: Taxpayers who are married and filing a joint tax return must use this filing status.
Married Filing Separately: This status should be used by married couples choosing to file separate tax returns. Married taxpayers may desire to prepare their taxes both jointly and separately before choosing whichever filing status yields a lower tax liability.
Head of Household: To be eligible for this filing status, a taxpayer must be unmarried, have at least one dependent or qualifying person, and have paid more than half the cost of keeping up a home for the year. In some cases, a custodial parent who is married but separated may qualify for head of household status.
Qualifying Widow(er) with Dependent Child: Taxpayers are eligible for this filing status for two years following the year of a spouse’s death if they meet the following requirements:
The taxpayer was entitled to file a joint return with their spouse for the year in which their spouse died.
The taxpayer can claim a child or stepchild as a dependent (this does not include a foster child).
The taxpayer paid more than half the cost of keeping up a home for the year.
Gross Income (GI)
Gross income refers to an individual’s or business’s taxable income before subtracting any adjustments or deductions. Examples of taxable income include wages, interest dividends, alimony, capital gains, and retirement income. Gross income can also take the form of property or services, taxable unemployment compensation, taxable social security benefits, and certain scholarship and fellowship grants.
Individual taxpayers and businesses alike are responsible for accurately reporting their gross income. For companies, the term “gross income” is interchangeable with the term “gross profit.” For example, a manufacturing business can calculate its gross income by subtracting the cost of goods sold and any miscellaneous income from the business’s total net sales. Rental property owners must include all income received from tenants—including rent as well as any other payments—in their gross income calculations. The cost of taxes, repairs, or other expenses cannot be deducted from this amount. If an individual taxpayer is a member of a partnership, his or her gross income must include their share of the gross partnership income.
Adjusted Gross Income (AGI)
Adjusted Gross Income (AGI) helps to determine individual taxpayers’ eligibility for certain deductions and credits. This provides a starting point for calculating their tax liability. AGI can be calculated by subtracting an individual’s adjustments to income, or “above-the-line” deductions, from their gross income.
Deductions reduce an individual’s amount of taxable income. Types of deductions include “above-the-line deductions” and “below-the-line deductions.” Above-the-line deductions, also known as adjustments to income, are subtracted from a taxpayer’s gross income to arrive at their adjusted gross income (AGI). After arriving at their AGI, taxpayers can choose from two types of below-the-line deductions. These include standard and itemized deductions; individuals typically choose whichever type results in a lower amount of taxable income. Taxpayers are eligible for above-the-line deductions regardless of whether they choose to itemize or take the standard deduction.
Also known as adjustments to income, above-the-line deductions are expenses that can be deducted directly from a taxpayer’s gross income to arrive at his or her adjusted gross income (AGI). Taxpayers can claim these deductions regardless of whether they take the standard deduction or choose to itemize.
Above-the-line deductions include the following, subject to limitations:
Deductible contributions to traditional IRAs (retirement savings accounts)
SIMPLE and Keogh plans
Contributions to HSAs (health savings accounts)
Penalties paid on early savings withdrawals
50% of the self-employment tax paid by self-employed taxpayers
Alimony payments for alimony agreements in place prior to December 31st, 2018
Interest paid on higher education loans and certain qualifying college costs (subject to limitations)
Jury duty pay forfeited to one’s employer
Qualifying travel expenses for members of the Reserves and National Guard
The standard deduction is a type of below-the-line-deduction comprised of a specific dollar amount that can be subtracted from a taxpayer’s adjusted gross income (AGI) to reduce their amount of taxable income. An individual’s standard deduction amount is determined by their filing status. Individuals over 65 years of age and those who are legally blind are entitled to an additional standard deduction.
Certain taxpayers are not eligible for the standard deduction. Ineligible taxpayers include:
An individual who is married, filing separately whose spouse itemizes deductions
Nonresident or dual status aliens
Individuals filing a return for a period of less than twelve months due to a change in their yearly accounting period
Estates, trusts, common trust funds, partnerships, S corporations, C corporations, or non-profits
Itemized deductions can be subtracted from one’s adjusted gross income (AGI) in lieu of the standard deduction. Taxpayers may opt to itemize their deductions if itemizing would result in a lower amount of taxable income than taking the standard deduction. Taxpayers who are ineligible for the standard deduction must itemize deductions. Expenses that qualify for itemized deductions include the following (subject to limitations):
Out-of-pocket medical and dental expenses
State and local taxes (SALT), subject to a $10,000 limit
Home mortgage points
Home mortgage interest expenses
Governments offer tax credits as incentives to promote certain behaviors or support disadvantaged taxpayers. Whereas tax deductions reduce the amount of taxable income before arriving at one’s final tax liability, tax credits are subtracted directly from taxes owed to the government. This reduces an individual’s tax liability dollar for dollar, whereas deductions reduce one’s tax liability by only a percentage of each dollar.
Tax credits can be either refundable or nonrefundable. If the total of an individual’s refundable tax credits is higher than their tax liability, the IRS passes along the difference in the form of a tax refund. Examples of refundable tax credits include the earned income tax credit and the first-time home-buyer credit. Nonrefundable credits, such as the credit for adoption expenses, cannot be used to create or increase a taxpayer’s refund. Some credits, such as the Child Tax Credit, are partially refundable.
Federal income and social security taxes are largely structured as “pay-as-you-go” tax systems. Employers withhold part of each employee’s paycheck throughout the year; this withheld amount goes toward the employee’s income taxes and social security taxes. A taxpayer’s withholding amount depends on their filing status, amount of income earned, and the number of withholding allowances claimed. Each withholding allowance reduces the taxpayer’s required withholding amount. Employees can also request that an additional amount be withheld from each paycheck. This is changing in 2019; due to the elimination of personal exemptions, the IRS is creating a new W-4.
The IRS encourages taxpayers to do a “Paycheck Checkup” early each year to determine their correct withholding amount. This is especially important for any taxpayer who received a tax bill with their most recent return; changing their withholding amount can help these taxpayers to avoid a tax bill with their next return. For taxpayers who didn’t owe taxes but received a smaller refund than expected with their most recent return, adjusting their withholding amount can help to ensure a larger refund the following tax season. The IRS also recommends checking one’s withholding amount in the case of a change in income or a major life event such as marriage or divorce, having a child, or buying a home.
You can perform your own “paycheck checkup” using the IRS’s withholding calculator here.
Estimated Tax Payments
Individuals who expect to make more than a certain amount of income for the year must make quarterly payments toward their annual tax bill if their income taxes are not covered by withholding.
Claiming one or more dependents can substantially lower an individual’s tax bill. A dependent is a person other than a taxpayer or their spouse who can be claimed on the taxpayer’s return. To qualify as a dependent, the person must be a qualifying child or a qualifying relative. Taxpayers with qualified dependents may be entitled to credits including the child tax credit, the earned income tax credit, or the new credit for dependents who do not qualify for the child tax credit. Prior to 2018, the personal exemption allowed taxpayers to reduce their taxable income for themselves and every dependent claimed; beginning with 2018 returns, this personal exemption has been suspended in favor of a higher standard deduction.
Marginal Tax Rate (MTR)
The marginal tax rate refers to the highest rate at which an individual pays income taxes, also known as their marginal tax bracket. This is a key component of the progressive income tax system employed by the U.S. A misconception exists that all of a taxpayer’s income is taxed at their marginal tax rate; in fact, only a portion of an individual’s income is taxed at this rate.
Consider the following example. For 2018, a taxpayer with an income of $83,000 would fall into the 24% tax bracket. The first $9,524 of their income would be taxed at 10%. Their income from $9,525 to $38,699 would be taxed at 12%. Their income from $38,700 to $82,499 would be taxed at 22%. Only the remaining income would be taxed at 24%.
Effective Tax Rate (ETR)
The effective tax rate is the average federal tax rate paid by an individual or corporation. An individual taxpayer can arrive at their effective tax rate by dividing their total tax expense by their taxable income. Corporations can calculate their effective tax rate by dividing their total tax expense by their earnings before taxes. An individual’s or corporation’s effective tax rate is usually lower than their marginal tax rate.
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