In our articles we will frequently use tax-specific phrases that while second nature to us, may be confusing to many of our readers. To clear up some of that confusion we have provided some definitions for the most common phrases below.
Adjusted Gross Income
Adjusted Gross Income (AGI) is defined as gross income minus adjustments to income. Gross income includes your wages, dividends, capital gains, business income, retirement distributions as well as other income. Adjustments to Income include such items as Educator expenses, Student loan interest, Alimony payments or contributions to a retirement account. Many deductions and credits on your tax return are determined by your AGI.
Tax Credits vs Tax Deductions
There are two ways your tax burden can be reduced: Tax Credits which directly reduce your tax bill, and tax deductions which indirectly reduce your tax bill by lowering the amount of your taxable income.
Let’s say you have taxable income of $10,000 which is taxed at 25%, your tax bill on that income is $2,500. If you receive a tax deduction of $1,000 it will bring your taxable income down to $9,000, reducing your tax bill to $2,250 and saving you $250. IF instead you have a tax credit of $1,000 it will directly reduce your $2,500 tax bill down to $1,500, saving you the full $1,000.
Your filing status determines the deductions and credits you qualify for and how much tax you pay on your income. Depending on your situation, you may qualify for more than one filing status, in which case you can choose the one more beneficial to you. These are the five filing statuses:
Single. This is the normal filing status for taxpayers who are not married or who are legally separated
Married Filing Jointly. Taxpayers who are married can file a joint tax return, reporting all of their income and expenses together
Married Filing Separately. Taxpayers who are married can instead choose to file separate tax returns, each reporting their own income and expenses. It is generally better to file a joint return to keep taxes low, but in rare circumstances it can be more beneficial to file separate.
Head of Household. Taxpayers who are unmarried and provide more than half the cost of maintaining a home for themselves and at least one other qualifying person can file head of household. This filing status provides larger deductions and lower tax rates than filing single making it the best option for taxpayers who qualify.
Qualifying Widow(er) with Dependent Child. Taxpayers whose spouse died within the last 2 years can choose this filing status if they have a dependent child. This status allows them to claim the same deductions and tax rates as if they were filing a joint tax return.
Your filing status for any given year is determined by your marital status on the last day of the year. A couple who get married December 31st can file a joint return for that year even though they were unmarried for the majority of the year. This rule does not apply in the death of a spouse. When a spouse dies the surviving spouse can file a joint tax return for the year of death.
Itemized Deductions vs Standard Deduction
There are two ways you can take deductions on your tax return: you can itemize deductions or use the standard deduction. The standard deduction is a set amount and is based on your filing status. If you itemize your deductions you will take the actual amount you spent on allowable deductions which include:
Mortgage interest paid on your personal residence
State income taxes paid
Real estate taxes paid on your personal residence
Medical expenses paid including out-of-pocket premiums paid
Each of these deductions is subject to various limitations. Since the passage of the Tax Cuts and Jobs Act in 2017, most taxpayers will benefit more from taking the standard deduction than from itemizing their deductions.