Tax Terms and Definitions You Should Know

 

When discussing taxes, reading tax related articles or interpreting instructions, one needs to understand the lingo and acronyms used by tax professionals and authors to be able to grasp what they are saying. It can be difficult to understand tax strategies if you are not familiar with the basic terminologies used in taxation. The following provides you with the basic details associated with the most frequently encountered tax terms.  

 

See Relax Tax’s Tax Audit Assistance at relaxtax.com/audit

 

Filing Status Definition

Generally, if you are married at the end of the tax year, you have three possible filing status options: married filing jointly, married filing separately, or, if you qualify, head of household. If you were unmarried at the end of the year, you would file as single, unless you qualify for the more beneficial head of household status. A special status applies for some widows and widowers.

When using the married joint status, the income, deductions and credits of the spouses are combined for reporting on the tax return. If the spouses file using the married separate status, they each file a separate tax return, and if they reside in a separate property state, each spouse includes just his or her own income and deductions on their individual return. In community property states, generally the incomes and deductions of the spouses are combined and then split 50%/50% for married separate tax return reporting purposes.

Head of household is the most complicated filing status to qualify for and is frequently overlooked as well as incorrectly claimed. Generally, the taxpayer must be unmarried AND:

• pay more than one half of the cost of maintaining as his or her home a household that was the principal place of abode for more than one half of the year of a qualifying child or certain dependent relatives, or
• pay more than half the cost of maintaining a separate household that was the main home for a dependent parent for the entire year.

A married taxpayer may be considered unmarried for the purpose of qualifying for head of household status if the spouses were separated for at least the last six months of the year, provided the taxpayer maintained a home for a dependent child for over half the year.

 

 

See this related post from Dennis Harabin: Filing as Married Separate? Better Read This.

Married taxpayers have two options when filing their 1040 or 1040-SR tax returns. The first and most frequently used filing status is married filing joint (MFJ), where the incomes and allowable expenses of both spouses are combined and reported on one tax return. The joint status almost always results in the lowest overall tax. Spouses who file together are jointly liable for the tax, meaning either or both can be held responsible for paying the tax from the joint return. 

 

 

Surviving spouse (also referred to as qualifying widow or widower) is a rarely status used only for a taxpayer whose spouse died in one of the prior two years and who has a dependent child at home. Joint rates are used. In the year the spouse passes away, the surviving spouse may file jointly with the deceased spouse if not remarried by the end of the year.

In rare circumstances, for the year of a spouse’s death, the executor of the decedent’s estate may determine that it is better to use the married separate status on the decedent’s final return, which would then also require the surviving spouse to use the married separate status for that year.

 

Adjusted Gross Income (AGI)

AGI is the acronym for adjusted gross income. AGI is generally the sum of a taxpayer’s income less specific subtractions called adjustments (but before the standard or itemized deductions). The most common adjustments are penalties paid for early withdrawal from a savings account, and deductions for contributing to a traditional IRA or self-employed retirement plan. Many tax benefits and allowances, such as credits, certain adjustments, and some deductions are limited by a taxpayer’s AGI.

Modified AGI (MAGI)—Modified AGI is AGI (described above) adjusted (generally up) by tax-exempt and tax-excludable income. MAGI is a significant term when income thresholds apply to limit various deductions, adjustments, and credits. The definition of MAGI will vary depending on the item that is being limited.

 

See this related post from Dennis Harabin: A Special Tax Benefit for Inheritances to Enjoy

 

 

What is considered as Taxable Income?

Taxable income is AGI less deductions (either standard or itemized). For years 2018 through 2025, another item that is subtracted when figuring taxable income is the deduction for qualified business income (generally 20% of qualified income from pass-through businesses such as partnerships, rentals and sole proprietorships). Your taxable income is what your regular tax is based upon using a tax rate schedule specific to your filing status. The IRS publishes tax tables that are based on the tax rate schedules and that simplify the tax calculation, but the tables can only be used to look up the tax on taxable income up to $99,999.

 

See this related post from Dennis Harabin: Choosing the Right Tax Filing Status

The couple combines their incomes, deductions, and credits on a jointly filed return. They are jointly and separately liable for the tax determined on the return. Because filing status is based on the taxpayers’ marital status on December 31 of each year, this means that couples who marry during the year, regardless of the date of the marriage, are eligible to file MFJ . Likewise, those who divorce during the year are not qualified to file MFJ for the year when the divorce is made final. A couple that is separated but still married as of December 31 may file either MFJ or Married Filing Separate (or possibly Head of Household, as explained below), and neither spouse can file using the single status. 

 

Marginal Tax Rate (Tax Bracket)

How to find marginal tax rate?

Not all of your income is taxed at the same rate. The amount equal to your standard or itemized deductions is not taxed at all. The next increment is taxed at 10%, then 12%, 22%, etc., until you reach the maximum tax rate, which is currently 37%. When you hear people discussing tax brackets, they are referring to the marginal tax rate.

Knowing your marginal rate is important because any increase or decrease in your taxable income will affect your tax at the marginal rate. For example, suppose your marginal rate is 24% and you are able to reduce your income $1,000 by contributing to a deductible retirement plan. You would save $240 in federal tax ($1,000 x 24%). Your marginal tax bracket depends upon your filing status and taxable income. You can find your marginal tax rate using the table below.

Keep in mind when using this table that the marginal rates are step functions and that the taxable incomes shown in the filing-status column are the top value for that marginal rate range.

 

 

2019 MARGINAL TAX RATES
TAXABLE INCOME BY FILING STATUS
Marginal Tax Rate	Single	Head of Household	Joint*	Married Filing Separately
10%	9,700	13,850	19,400	9,700
12%	39,475	52,850	78,950	39,475
22%	84,200	84,200	168,400	84,200
24%	160,725	160,700	321,450	160,725
32%	204,100	204,100	408,200	204,100
35%	510,300	510,300	612,350	306,175
37%	Over 510,300	Over 510,300	Over  612,350	Over 306,175

  * Also used by taxpayers filing as surviving spouse

 

Capital Gains Tax Rates – Lower tax rates apply for gains upon sale of most property, such as stocks and real estate, held for over one year. These rates are 0%, 15% and 20%. Which rate applies depends on the amount of your taxable income.

• Taxpayer & Dependent Exemptions—Prior to the changes made by the 2017 tax reform you were allowed to claim a personal exemption for yourself, your spouse (if filing jointly), and each individual qualifying as your dependent. The deductible exemption amount was adjusted for inflation annually; the amount for 2019 is $4,200. However, the tax reform suspended the deduction for exemptions for 2018 through 2025. 

 

 

 

Claiming Dependents on Taxes

To qualify as a dependent, an individual must be the taxpayer’s qualified child or pass all five dependency qualifications: the (1) member of the household or relationship test, (2) gross income test, (3) joint return test, (4) citizenship or residency test, and (5) support test. The gross income test limits the amount a dependent can make if he or she is over 18 and does not qualify for an exception for certain full-time students. The support test generally requires that you pay over half of the dependent’s support, although there are special rules for divorced parents and situations where several individuals together provide over half of the support.

• Qualified Child—A qualified child is one who meets the following tests:

(1) Has the same principal place of abode as the taxpayer for more than half of the tax year except for temporary absences;

(2) Is the taxpayer’s son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any such individual;

(3) Is younger than the taxpayer;

(4) Did not provide over half of his or her own support for the tax year;

(5) Is under age 19, or under age 24 in the case of a full-time student, or is permanently and totally disabled (at any age); and

(6) Was unmarried (or if married, either did not file a joint return or filed jointly only as a claim for refund).

• Deductions— A taxpayer generally can choose to itemize deductions or use the standard deduction. The standard deductions, which are adjusted for inflation annually, are illustrated below for 2019. 

 

 

 

Filing Status	Standard Deduction
Single	$12,200
Head of Household	$18,350
Married Filing Jointly	$24,400
Married Filing Separately	$12,200

 

The standard deduction is increased by multiples of $1,650 for unmarried taxpayers who are over age 64 and/or blind. For married taxpayers, the additional amount is $1,300. The extra standard deduction amount is not allowed for elderly or blind dependents. Those with large deductible expenses can itemize their deductions in lieu of claiming the standard deduction. The standard deduction of a dependent filing his or her own return will oftentimes be less than the single amount shown above.

 

 

Common Itemized Deductions:

(1) Medical expenses which are limited to those that exceed 10% of your AGI for 2019.

(2) Taxes consisting primarily of real property taxes, state income (or sales) tax, and personal property taxes, but limited to a total of $10,000 for the year.

(3) Interest on qualified home acquisition debt and investments; the latter is limited to net investment income (i.e., the deductible interest cannot exceed your investment income after deducting investment expenses).

(4) Charitable contributions, generally limited to 60% of your AGI, but in certain circumstances the limit can be as little as 20% or 30% of AGI.

(5) Gambling losses to the extent of gambling income, and certain other rarely encountered deductions.

 

 

See this related post from Dennis Harabin: Tax Issues That You Can Expect From Gambling

Although gambling may seem to be a recreational activity for many taxpayers it is not for THE government. They look at it as a source of tax revenue and as one might expect, the government takes a cut if a gambler wins. What makes matters worse, tax laws do not allow recreational gamblers to claim a loss in excess of their winnings. There are far more tax issues related to gambling than one might expect, and they may impact taxes in more ways than one might believe.

 

 

Alternative Minimum Tax (AMT)

The Alternative Minimum Tax is another way of being taxed that has often taken taxpayers by surprise. The Alternative Minimum Tax (AMT) is a tax that was originally intended to ensure that wealthier taxpayers with large write-offs and tax-sheltered investments pay at least a minimum tax. However, even taxpayers whose only “tax shelter” is having a large number of dependents or paying high state income or property taxes were being affected by the AMT.

Your tax must be computed by the regular method and also by the alternative method. The tax that is higher must be paid. The following are some of the more frequently encountered factors and differences that contribute to making the AMT greater than the regular tax.

• The standard deduction is not allowed for the AMT, and a person subject to the AMT cannot itemize for AMT purposes unless he or she also itemizes for regular tax purposes. Therefore, it is important to make every effort to itemize if subject to the AMT.
• Itemized deductions:   
• Interest in the form of home equity debt interest that cannot be traced to a deductible use. For years 2018–2025, interest paid on home equity debt is also not allowed for regular tax purposes.
• Nontaxable interest from private activity bonds is tax free for regular tax purposes, but some is taxable for the AMT.
• Statutory stock options (incentive stock options) when exercised produce no income for regular tax purposes. However, the bargain element (difference between grant price and exercise price) is income for AMT purposes in the year the option is exercised.
• Depletion allowance in excess of a taxpayer’s basis in the property is not allowed for AMT purposes.

A certain amount of income is exempt from the AMT, but the AMT exemptions are phased out for higher-income taxpayers.  

 

 

AMT EXEMPTIONS & PHASE OUT - 2019
Filing Status	Exemption Amount	Income Where Exemption Is Totally Phased Out
Married Filing Jointly	$111,700	$1,467,400
Married Filing Separate	$55,850	$797,100
Unmarried	$71,700	$733,700

 

AMT TAX RATES—2019
AMT Taxable Income	Tax Rate
0 – $194,800 (1)	26%
Over $194,800 (1)	28%

(1) $97,400 for married taxpayers filing separately

 

Your tax will be whichever is the higher of the tax computed the regular way and by the Alternative Minimum Tax. Anticipating when the AMT will affect you is difficult, because it is usually the result of a combination of circumstances. In addition to those items listed above, watch out for transactions involving limited partnerships, depreciation, and business tax credits only allowed against the regular tax. All of these can strongly impact your bottom-line tax and raise a question of possible AMT.

Fortunately, due to tax reform that the increased AMT exemption amounts and set higher thresholds before the exemption is phased out, fewer taxpayers are now paying AMT. Tax Tip: If you were subject to the AMT in the prior year, you itemized your deductions on your federal return for the prior year, and had a state tax refund for that year, part or all of your state income tax refund from that year may not be taxable in the regular tax computation. To the extent that you received no tax benefit from the state tax deduction because of the AMT, that portion of the refund is not included in the subsequent year’s income.

 

Tax Credits & Underpayment of Estimated Tax Penalty

Once your tax is computed, tax credits can reduce the tax further. Credits reduce your tax dollar for dollar and are divided into two categories: those that are nonrefundable and can only offset the tax, and those that are refundable. In addition, some credits are not deductible against the AMT, and some credits, when not fully used in a specific tax year, can carry over to succeeding years. Although most credits are a result of some action taken by the taxpayer, there are some commonly encountered credits that are based simply on the number or type of your dependents or your income. These and other popular credit are outlined below.

• Child Tax Credit—Thanks to tax reform the child tax credit has been increased to $2,000 per child (up from $1,000 in 2017). If the credit is not entirely used to offset tax, the excess portion of the credit, up to the amount that the taxpayer’s earned income exceeds a threshold of $2,500, but not more than $1,400, is refundable. The credit begins to phase out at incomes (MAGI) of $400,000 for married joint filers and $200,000 for other filing status. The credit is reduced by $50 for each $1,000 (or fraction of $1,000) of modified AGI over the threshold.
• Dependent Credit – A nonrefundable credit is available to taxpayers with a dependent who isn’t a qualifying child, and like the increased child tax credit is designed to offset the loss of the exemption deduction as a result of tax reform. The dependent credit is $500. A qualifying child, the taxpayer, and if married, the spouse are not eligible for this credit. A child who isn’t a qualifying child but who qualifies as a dependent under the dependent relative rules would qualify the taxpayer to claim this credit.

 

 

 

IRS Earned Income Credit 

This is a refundable credit for a low-income taxpayer with income from working either as an employee or a self-employed individual. The credit is based on earned income, the taxpayer’s AGI, and the number of qualifying children. A taxpayer who has investment income such as interest and dividends in excess of $3,600 (for 2019) is ineligible for this credit. The credit was established as an incentive for individuals to obtain employment. It increases with the amount of earned income until the maximum credit is achieved and then begins to phase out at higher incomes. The table below illustrates the phase-out ranges for the various combinations of filing status and earned income and the maximum credit available.

 

2019 EIC PHASE-OUT RANGE
Number of Children	Joint Return	Others	Maximum Credit
None	$14,450 – $21,370	$8,650 – $15,570	$529
1	$24,820 – $46,884	$19,030 – $41,094	$3,526
2   3	$24,820 – $52,493 $24,820 – $55,952	$19,030 – $46,703   $19,030 – $50,162	$5,828   $6,557

 

• Residential Energy-Efficient Property Credit—This credit is generally for energy-producing systems that harness solar, wind, or geothermal energy, including solar-electric, solar water-heating, fuel-cell, small wind-energy, and geothermal heat-pump systems. These items qualify for a 30% credit with no annual credit limit. Unused residential energy-efficient property credit is generally carried over through 2021.The credit rate reduces to 26% in 2020 and 22% in 2021. The credit expires after 2021.
• Withholding and Estimated Taxes—Our “pay-as-you-earn” tax system requires that you make payments of your tax liability evenly throughout the year. If you don’t, it’s possible that you could owe an underpayment penalty. Some taxpayers meet the “pay-as-you-earn” requirements by making quarterly estimated payments. However, when your income is primarily from wages, you usually meet the requirements through wage withholding and rely on your employer’s payroll department to take out the right amount of tax, based on the information shown on the Form W-4 that you filed with your employer. To avoid potential underpayment penalties, you are required to deposit by payroll withholding or estimated tax payments an amount equal to the lesser of:
• 90% of the current year’s tax liability; or
• 100% of the prior year’s tax liability or, if your AGI exceeds $150,000 ($75,000 for taxpayers filing as married separate), 110% of the prior year’s tax liability.

 

See this related post from Tuition Tax Break for Parents with Children with Special Needs

A component of itemized deductions is the cost of medical care. The total of eligible medical expenses paid during the tax year is reduced by 7.5% of the taxpayer’s adjusted gross income (AGI). While you are undoubtedly familiar with most of the medical expenses eligible for the deduction, such as payments for doctor/dentist care, surgeries, prescription drugs and other commonly encountered medical costs, one type of eligible medical expense that you may not be aware of is the cost of a child attending a special school. This type of school is designed to compensate for or overcome a physical or mental handicap, in order to qualify the individual for future normal education or for normal living. This includes a school for the teaching of Braille or lip reading. The principal reason for attending must be the special resources available at the school for alleviating the handicap.

 

If you had a significant change in income during the year, we can assist you in projecting your tax liability to maximize the tax benefit and delay paying as much tax as possible before the filing due date.

Feel free to reach out to this office at 551-249-1040 with any questions or concerns regarding your tax planning needs. 

 

Dennis Harabin at Relax Tax is an expert in taxes, insurance, and debt. Contact him today! 

 

Recommended Readings:

2022 Tax Season: Another Hectic Year for IRS and Taxpayers?

Advance Child Tax Credit and EIP Must Be Reconciled on Your 2021 Return

The Benefits of Filing a Tax Return

Tax Benefits for Holiday Gifts

Disability Tax Benefits and Tax Credits