Minimizing your tax liability starts with knowing tax terminology. Learn the terms you need to know well before April 15 is upon you.
For some, the thought of tax preparation means countless hours spent shuffling through papers; for others, it means trying to avoid an unexpected tax bill. But according to Katherine Goad, Instructional Designer for the National Association of Tax Professionals, minimizing your tax liability—or even getting a refund—takes just a little planning ahead of time, not marathon sessions of wrestling with tax forms.
“You can do things throughout the year like changing your withholdings or making contributions to your IRA so you can control how much refund or tax payment you make,” she said.
Before you begin shifting around finances to minimize the pain of April 15, it’s important to first understand some basic tax terminology. Here are some basic concepts Goad recommends understanding:
Gross Income
This is the full amount of money, goods, services, and property you receive and must report in a year, which includes wages, stock sales, interest income, IRA distributions, and rental income. While it also includes unemployment compensation and some scholarships, gross income does not include some welfare benefits and nontaxable Social Security benefits.
Adjusted Gross Income
Adjusted gross income is income before deductions and exemptions. This is your gross income following adjustments such as a deductible IRA contribution, student loan interest, expenses associated with a move for a job, alimony, and more.
Deductions
Deductions can lower the amount of tax you ultimately pay. There are two types of deductions: Standard deductions offer one deduction amount based upon your filing status, age, blindness, and whether someone else can claim you as a dependent. Itemized deductions list out each possible tax deduction for items such as mortgage interest, medical expenses, charitable gifts, business expenses, and more. You’ll want to choose the greater of the two deductions.
If you are self-employed, Goad advises looking into adjustments and deductions you might be able to take based on your self-employment costs such as health insurance, business expenses, and part of your self-employment tax.
Exemptions
Like deductions, a tax exemption reduces your taxable income. There are several types of tax exemptions but only two that you will likely need to understand: One personal exemption each for you and your spouse. Additionally, if you have eligible dependents — including children living in your household and, in some cases, additional family members who are considered dependents — you may qualify for dependent exemptions.
Credits
Tax credits act in a different way than deductions and exemptions because they give you credit on your actual tax payment, as opposed to reducing your taxable income. If your tax credits are more than your payment, you may even receive a tax refund. Talk to a tax professional or learn more about the different types of credits available on the IRS website.
Withholding
This is the money your employer withholds from your paycheck that is credited against your annual tax payment when filing your return. Goad says it’s important to estimate your tax liability early so that, if you anticipate having to pay more at the end of the year, you can ask your employer to withhold a larger amount from your paycheck so that you don’t get hit with a big payment during tax time.
Because expenses and life changes that could affect your tax liability come at different times of year, Goad suggests planning your taxes early and not waiting until tax time to meet with a tax professional. That way, you’ll have advance notice if you need to increase your withholdings or put more into a retirement account to reduce your taxable income.
“If you go in during the summer, you’ll be able to plan for the second half of the year,” she said. “To smooth out the changes you want, the sooner the better.”
Ready to start your tax-planning journey? Learn what your next steps are to help guide your tax preparation.
