What is the difference between a credit and a deduction?
What is taxable income and earned income?
Should I take the standard deduction?
When you’re sitting down to do your taxes, it might feel like you’re reading a foreign language. I mean, you probably know what a lot of the words mean independently, but sometimes when they’re combined with other words, things can get confusing. If you’re new to the tax world, or you’d like to become better informed on some of that fancy-pants tax lingo, you’ve come to the right place. We’ve compiled a list of key tax terms to help keep better track of your money.
Your liability is the amount of taxes that you are responsible for paying to the federal (and sometimes state) government. Your liability is determined by:
- How much income you bring in
- Whatever exemptions you claim
- Other capital gains
- Self-employment taxes
- Any back taxes you might owe
- Early distribution from a retirement account
Your total liability can seem like a horrifyingly high amount before you apply credits, payments, and other deductions. The tricky part is figuring out what is considered income for tax purposes and finding out what exemptions, deductions and credits you can claim. Once you do that, your total liability may be much more reasonable.
Earned income is the money that you receive from active participation in a trade or business, including wages, salary, tips, commissions, and bonuses (or profits from operating a business if you are self-employed). It is different from the passive money you make through dividends, stipends, grants, social security, or capital gains (money made from selling an asset like stock or real estate).
Taxable income is the money that produces a tax liability. The long and short is that all income is taxable income unless it is explicitly excluded by the IRS rules. The IRS does not consider some cash receipts to be taxable income, such as payment by federal and state governments (ex: foster parent reimbursement), WIC, SNAP, unemployment benefits, stipends for university research, or Social Security.
A tax credit is an amount of money that you can subtract from the taxes that you owe. It is more valuable than a tax deduction, which only reduces the amount of taxable income. Basically, a credit is the government cutting you a break for certain things. Some common credits you may have heard of include:
- Earned Income Tax Credit (EITC): This credit is for taxpayers that have an earned income below a certain level. That level varies state to state, so you’ll need to check on it depending on where you live. The EITC makes it so that you may be able to receive a refund whether or not you have any tax liability.
- Child and Dependent Care Credit/Child Tax credit and Credit for Other Dependents: In the world of parenting where every penny counts, these credits can be a lifesaver. These credits can give you a break on childcare and other kid-related expenses because kids are expensive.
- American Opportunity Credit: This credit can help offset the cost of continuing education past high school.
When you’re going through your credits, you’ll come across two terms that are different in an important way.
- Refundable Credits: If a tax credit is refundable, it means that if your credit exceeds the amount of taxes owed, you can get a refund for that money. As a quick example, if you have a $600 tax liability, but a $1,000 refundable credit, you could get $400 back in a return. Some tax credits are only partially refundable, such as the American Opportunity tax credit, which is 40% refundable.
- Non-Refundable Credits: A non-refundable tax credit is exactly what it sounds like in that these credits can reduce your tax liability to $0, but they do not generate a refund. Using our example from above, if you have a $600 tax liability and a $1,000 non-refundable credit, your tax liability would be reduced to $0, and you would owe no taxes. The $400 excess just takes a train to the land of non-refunded money.
Deductions reduce the amount of taxable income that you have, which lowers your tax liability. There are two ways to go about recording your deductions: itemized or standard.
- Itemized: Some of the items that are most commonly deducted in an itemized deduction include:
- Medical and dental expenses
- Charitable contributions
- Business use of a car or home
- Business travel expenses
- Disaster or theft losses
- Interest expense
- Home mortgage points.
For more information on itemized deductions, visit this website.
- Standard: The Standard Deduction for the 2019 tax year is $12,200 for individuals, or $24,400 for married couples filing jointly. If you’ve tallied up all of your itemized deductions and they equal less than the standard deduction, you should probably take the standard deduction. Remember: your goal is to zero out your tax liability, so the more deductions you can apply, the better.
The W-2 is the “Wage and Tax Statement” form, and it’s the form that your employer sends you and the IRS each year that reports how much you made and how much was taken out in taxes.
This is the important piece of tax information that you fill out when you first start employment. On it, you will declare how many exemptions you want to claim for each paycheck. The more exemptions you claim, the more money you’ll take home from each paycheck, and the smaller your return will be. Essentially, each time you claim an exemption, you’re telling the government that you need those funds now instead of paying in extra and getting a large return the following year. If you like getting that big chunk of change, you should claim fewer exemptions, but remember, you’re basically giving the government an interest-free loan, and you could be making the most of that capital throughout the year with some smart investing.
As a side note, there is such thing as a W-1 and a W-3, but they aren’t commonly used by the average Joe.
If you work for someone else, or have paid someone else at least $10 in royalties, or $600 in rents, services, prizes, other income, etc., you are responsible for filing a form 1099-MISC with the IRS. If you have received money from someone else, you should receive Copy B of the form. Essentially, if you are an independent contractor, you will likely receive a 1099-MISC for your work. Be cautious because it is not uncommon for employers to try to incorrectly classify employees as independent contractors and “1099” them, which is fraudulent. Double-check with your state’s tax laws before you let yourself be classified this way by your employer.
The dreaded 1040. This is the actual form that you use to file your tax return. If you’re using tax preparation software, often the program you are using will automatically populate the fields you are supposed to fill out for your return. If you have a relatively simple return, you may be able to do this yourself by following the instructions on the form.
If your bank paid out interest on any account that you hold, you will receive a 1099-INT. This form tracks the amount of interest generated on your accounts for tax purposes.
Like the 1099-INT, if you received dividends from a company or other entity, you will receive a 1099-DIV, which is a form used to track those dividends for tax purposes.
This list should put you on a path to understanding more about taxes, but if you need the help of experts—especially if you have tax debt that needs to be resolved—contact our tax relief lawyers to help you get square with the IRS in a way that is the most financially advantageous for you.