It’s about that time of year again: tax season. If you typically get a refund this can be a great time of year, and you may look forward to it! For others tax time brings anxiety, frustration, and a big bill. Add to this how confused many of us feel over common tax terms and it all becomes one big headache! Learning these key tax terms can ease that headache a bit, and help you avoid trouble with the “tax wo/man.”
Before you even think about filing taxes, you will have to figure out how many allowances to claim on your W-4 form. This determines how much will be taken out of your check each payday – the lower the number of allowances you claim, the larger the sum of money to be taken out for taxes, and vice versa. Some may purposefully keep their allowances low in order to get a bigger tax refund at tax time – talk about enforced saving! Others may intentionally raise their allowances to increase their take-home pay. While there may be nothing wrong with that, it is risky and may result in a large tax bill the following year.
In my opinion, the best thing to do is to make sure you neither have too little nor too much withheld from your taxes. The biggest benefit of this is avoiding a tax bill, and if you budget smartly you can set up automatic savings that will earn you interest! You can determine the correct number of allowances to claim by completing the worksheet found on the W-4 form, or complete a “paycheck checkup” with the withholding calculator at the IRS website. Tax season isn’t the only good time to complete a paycheck check-up, however!
2. Tax Credits
Tax credits reduce your tax bill by giving you dollar-for-dollar credit towards what you owe (e.g. if you are eligible for a $500 tax credit your tax bill will be reduced by $500). They can be refundable or non-refundable.
Non-refundable Tax Credits
Non-refundable tax credits are the most common and can be used to reduce your tax to zero, but not below. Some common examples of non-refundable tax credits include the Adoption Tax Credit, the Child Tax Credit, and the Mortgage Interest Tax Credit.
Refundable Tax Credits
Refundable tax credits allow you to reduce your tax liability and will provide a refund. The most well-known example of a refundable tax credit is the Earned Income Tax Credit, which is a poverty-fighting measure that essentially provides a subsidy for low-income working families (learn about eligibility).
Partially-refundable Tax Credits
There are also partially-refundable tax credits. As the name implies, these credits will reduce your tax bill, but if it goes below zero only a portion of the credit may be refunded. They are really quite complicated. A good example of a partially-refundable tax credit is the American Opportunity Tax Credit, which is a credit for tuition paid at higher institutions of learning (learn more about education related tax benefits).
3. Tax Deductions
Deductions reduce the amount of income you must pay tax on. Unlike a tax credit they are not dollar-for-dollar, but reduce your taxable income at a level equal to the percentage of your marginal tax bracket (see below). For example, if you’re in the 25% tax bracket, a $500 tax deduction will save you $125 in taxes (because 0.25 × $500 = $125).
Some deductions reduce your taxable income immediately like payroll-deductions: these may include pre-tax medical insurance premiums, dental insurance premiums, retirement account contributions, flex spending accounts, and Health Savings Accounts. Your employer may offer even more pre-tax deductions than this.
Other deductions reduce your income at a later date, like when you are figuring out how much tax you owe. The Standard Deduction reduces your taxable income by $12,000 for single people and $24,000 for married couples in 2018.
You may be able to further reduce your taxable income through itemized deductions for things like student loan interest payments, state sales or income tax reductions, Military Reserve travel expenses, or job hunting expenses! Make sure to explore which deductions you qualify for when preparing your taxes (or having someone else do it for you), or review the list of deductions from the IRS.
A note about Credits and Deductions: the rules and eligibility can change from year-to-year, so eligibility for one or the other one year, doesn’t guarantee eligibility the next.
4. Filing Status
There are four different ways you can file your taxes:
- Married filing jointly
- Married filing separately
- Head of Household
Your filing status matters in many ways; it will determine how much you can claim for a standard deduction, which credits and deductions you may be eligible for, and which tax bracket you ultimately end up in. If you are married, filing separately may significantly increase your tax liability, so make sure you research the impact this could have on your situation if you are considering this, or consult a tax professional.
You may have heard of terms like marginal and effective tax rate, but what do they mean? Tax brackets determine what your tax rate will be, and there are seven different tax brackets for 2018. When coupled with Filing Status, that means there are 28 possible tax rates! Brackets are where many misunderstandings of tax rates occur. Let me break it down for you.
Your income is taxed at different rates at different levels rather than your entire income being taxed at a single rate. Let’s say your taxable income is $50,000 and your filing status is Single. Here is how that income will get taxed:
- The first $9,524 is taxed at 10% ($952.40)
- The next $29,175 is taxed at 12% ($3,501)
- The last $11,301 is taxed at 22% ($2,486)
Okay, so that’s about $6,939, (rounded down) that you may owe in taxes. In this scenario your marginal tax rate would be 22% because that is the rate of the last dollar you were taxed.
Your effective tax rate is the amount you pay on your total income. This number is calculated by dividing your taxable income by the total amount of taxes paid. In this scenario, effective tax rate is 13.9% (13.9% of $50,000 = $6,939).
There you have it: five key terms to help you understand your taxes better and get ready to file away!
Not ready to figure it out on your own? See if you qualify for one of several free filing options! Check out free filing programs at the IRS website, visit your local VITA (Volunteer Income Tax Assistance) location if your household earns under $54,000 a year, or your local TCE (Tax Counseling for the Elderly) location for free help in filing taxes (locate an office near you here). Individuals, Families, and Small business owners in Minnesota who earn under $55,000 ($35,000 for individuals) can meet with Prepare and Prosper to free help with their taxes.
Author Shannon Doyle is a certified LSS Financial Counselor.