Even when we’re not in the throes of tax time, it’s a good idea to have an idea of what certain federal income tax terminology means.
Understanding how taxes work can go a long way toward helping you plan ahead. After all, you want to be able to pay Uncle Sam as little as legally possible.
Here are a few terms every taxpayer should understand in order to make the most of their money.
1. Total income
Your total income, sometimes also referred to as “gross income,” is the total amount of your income that must be reported on your federal tax return — before any adjustments (deductions) are made. It includes wages, business income, investment income, withdrawals from retirement accounts and other types of income.
It’s important to note that you’re not taxed on your total income. But your total income is used to determine a key amount: your adjusted gross income.
Where to find it: Your total income is listed on your federal income tax return (IRS Form 1040).
2. Adjusted gross income (AGI)
Your adjusted gross income, or AGI, is your total income minus certain adjustments. Some of these adjustments include tax deductions for retirement account contributions, interest paid on student loans, spousal support (alimony) payments and certain expenses that school teachers pay out of pocket.
Where to find it: Your AGI is listed on your federal income tax return (IRS Form 1040).
3. Tax credit
A tax credit can reduce your tax bill — a dollar-for-dollar reduction. For example, a $100 credit would lower your tax bill by $100 — or possibly increase your tax refund by up to $100, depending on the type of credit.
The types of tax credits include:
- Nonrefundable tax credits can reduce your tax bill but don’t affect your tax refund. For example, if you owe $2,000 on your taxes but have nonrefundable credits amounting to $3,000, the credits will lower your tax bill to $0, but you don’t get the “leftover” $1,000.
- Refundable tax credits can increase your tax refund and can result in you receiving a refund — even if you don’t owe any taxes. For example, if you owe $2,000 on your taxes but have refundable credits amounting to $3,000, the credits lower your tax bill to $0 and you will receive a $1,000 refund.
- Partially refundable tax credits limit how much of the credit can be refunded to you. For example, a partially refundable credit might allow for up to 40% of the credit to be refunded. So, if you qualify for a $1,000 tax credit, and only 40% of it is refundable, it could only increase your tax refund by $400, not $1,000.
4. Tax deduction
A tax deduction can reduce your taxable income (as opposed to reducing your tax bill). So, deductions are less valuable than credits overall.
The value of a tax deduction depends on your tax rate. Say your tax rate is 22%. A $100 deduction could lower your taxable income by $100, and that in turn could lower your tax bill by $22 (22% of the $100 deduction).
5. Standard deduction
The standard deduction is a flat amount that reduces your taxable income.
The amounts of standard deductions are based on tax-filing status and are adjusted each year to account for inflation. For people under age 65, the standard deduction amounts for the 2022 tax year — the one for which your return is due in April 2023 — are:
- $25,900 for married filing jointly or surviving spouse
- $19,400 for head of household
- $12,950 for single or married filing separately
For people who are 65 or older or blind, the standard deduction amounts are slightly higher.
Not everyone is eligible for the standard deduction, however. For example, if you are married, you file a separate tax return from your spouse and your spouse itemizes their deductions, you are not eligible to take the standard deduction.
Where to find it: If you choose to take the standard deduction, it will be listed on your federal income tax return (IRS Form 1040).
6. Itemized deduction
You have the choice to itemize your tax deductions instead of taking the standard deduction. With itemized deductions, which are listed on Schedule A of the tax return, you list out each deduction individually and the amount you paid.
In general, it makes sense to itemize your deductions only if the total amount of your itemized deductions is larger than your standard deduction.
For example, say you file your tax return as head of household and your itemized deductions total $20,000. Because your itemized total is more than your standard deduction ($19,400 for the 2022 tax year), you can reduce your taxable income by a greater amount by choosing to itemize your deductions.
Where to find it: If you choose to itemize your deductions, you must file an additional form detailing your itemized deductions — known as “Schedule A, Itemized Deductions” — along with your federal income tax return (IRS Form 1040).
7. Tax refund
If the amount of money that is withheld from your paychecks, or that you pay in quarterly advance tax payments, during a given year exceeds the amount of taxes you end up owing for that year, you’re owed money back from the IRS. This is your tax refund.
It’s important to note, however, that your tax refund is essentially an interest-free loan to the government. While some people like to use a tax refund as a forced savings vehicle, it’s also possible to reduce what you pay along the way and instead invest the difference. Depending on your situation, a big tax refund each year could actually result in an opportunity cost.
Consider using the free Tax Withholding Estimator from the IRS to get a better idea of how much you should have had taken from your paycheck in order to maximize the way you use your money.
Where to find it: If you receive a refund, it will be listed on your federal income tax return (IRS Form 1040).
8. Tax-advantaged account
Many accounts offer tax advantages, often to incentivize saving for retirement, health care or education. Here are several types of tax-advantaged accounts:
- 401(k) plan
- 403(b) plan
- Traditional individual retirement account (IRA)
- Roth IRA
- SEP and SIMPLE IRA
- Thrift Savings Plan
- Flexible spending account (FSA)
- Health savings account (HSA)
- 529 plan
- Coverdell Education Savings Account (ESA)
What these accounts have in common is that the money in them is shielded from taxes, either for a period of time (tax-deferred or pre-taxed) or completely (tax-free).
A tax-deferred account is one you can contribute to without paying taxes upfront. Your full contributions will be able to grow unhindered by taxes until it’s time to withdraw them, at which point you’ll owe taxes based on your current income tax rate. A traditional IRA is an example of a tax-deferred account.
A tax-free account, on the other hand, is one that isn’t taxed at all if you follow IRS rules for the account type. You are not taxed when you put money in, nor when you take money out. A properly used HSA is a tax-free account.
9. Required minimum distribution (RMD)
As the IRS says, “You cannot keep retirement funds in your account indefinitely.” At some point, you have to gradually start using them, or the IRS will penalize you. In general, this begins in the year you turn age 72.
The amount you are required to withdraw each year is called a required minimum distribution, although you have the option to withdraw more than this amount if you want. An RMD generally is considered taxable income.
Those who don’t make their RMDs on time will owe a penalty equal to 50% of the amount they failed to take out of the account.
The types of account subject to RMDs include:
- Traditional IRA
- SEP IRA
- SIMPLE IRA
- 401(k) plan
- 403(b) plan
- 457(b) plan
- Profit-sharing plan
- Other defined-contribution plans
Roth IRAs are not subject to RMDs.
The amount of an RMD varies. The IRS determines the amount by dividing the calendar year-end balance of each account by a number based on life expectancy.