Understanding how your taxes are calculated can help you avoid unpleasant surprises. A good place to start is by learning some common tax terms. This can help you fill out your tax return and/or make conversations with your tax accountant easier.
For some, the thought of tax preparation means countless hours spent shuffling through papers. Understanding how your taxes are calculated can help you avoid an unexpected tax bill. A good place to start is by learning some common tax terms, which can help you fill out your tax return or make conversations with your tax accountant easier.
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. It also includes unemployment compensation and some scholarships, but gross income does not include some welfare benefits and nontaxable Social Security benefits. It also does not include gifts, inheritances, and life insurance proceeds.
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, alimony, and more.
Tip: If you are self-employed, you may be able to take adjustments and deductions based on your self-employment costs such as health insurance, business expenses, and part of your self-employment tax.
Deductions
Deductions can lower the amount of tax you ultimately pay. There are two categories of deductions: standard and itemized. Standard deductions let you deduct a fixed amount from your taxable income based on criteria like your age and filing status. With itemized deductions, you list out expenses that qualify for a possible deduction, such as mortgage interest, medical expenses, charitable gifts, business expenses for self-employed taxpayers, and more. The IRS provides forms that help you translate those expenses into deductions, which you then subtract from your taxable income. Generally, you want to choose the greater of the two deductions. These deductions can vary by year as the tax code is adjusted, so it’s a good idea to check IRS.gov for the most up-to-date criteria.
Exemptions
A tax exemption reduces your taxable income. Each exemption you’re able to claim reduces your income by a set number. However, exemptions are repealed for individuals for the 2018 tax year. This elimination of personal and dependent exemptions is set to expire in 2025 but could be extended.
Credits
Tax credits are different from deductions and exemptions because they reduce your tax due dollar for dollar (as opposed to reducing your taxable income, which only reduces it by the percentage that you pay in tax). If certain tax credits reduce your tax below zero, 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.
Because expenses and life changes that could affect your tax liability come at different times of year, consider planning your taxes early and avoid waiting until tax time to meet with a tax professional. That way, you’ll have advance notice if you need to make any changes during the year.
Ready to start your tax-planning journey?
