Paying taxes can be a chore. But it’s all the more so when you’re wondering what exactly it is you’re being asked for, how income tax really works and what some common tax terms mean.
To help, here’s a guide to some of the most common tax terms and questions you might have, with brief explainers for each.
What is gross income? The sum of all your income before taxes – including from your job, your investments and your side hustles.
Gross income includes many different forms of income, such as your wages, dividends, taxable interest, capital gains, alimony, collected rent, unemployment compensation and distributions from your retirement accounts.
What is adjusted gross income? Your AGI is your gross income minus a number of expenses you incurred and contributions you made during the tax year, such as educator expenses, student loan interest, alimony payments and contributions to a tax-advantaged retirement account like a 401(k) or IRA.
Your AGI will determine your eligibility for a host of tax breaks.
What is taxable income? It’s the portion of all your income that is subject to taxation. For most people, it’s your AGI minus your deductions (or the standard deduction if you don’t itemize).
What is income tax? It’s the tax that federal, state and local governments assess on your income.
The federal tax system is progressive, meaning the more you make, the higher your tax rate on the last dollar you earn.
Here’s what that looks like: There are seven tax rates: 10%, 12%, 22%, 24%, 32%, 35% and 37%. Each rate applies to a different portion of your income.
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For example, for single filers, the 10% bracket applies to the first $9,950 of income you earn in 2021. The 12% rate applies to dollars $9,951 to $40,125. The 22% rate is applied to dollars $40,526 to $86,375, and so on up the scale. So if you only made $40,000 you’re in the 12% bracket, whereas someone who made $70,000 is in the 22% bracket. (See here for all 2021 income tax brackets based on filing status.)
What is the payroll tax? That’s the tax you pay to support the federal social safety net programs of Medicare and Social Security. It is also called the FICA tax.
The tax rate for Medicare amounts to 2.9% of all your earned income, whereas the Social Security tax rate is 12.4% and applies to the first $142,800 of your wages in 2021. (The wage base goes up by a few thousand dollars every year.)
Typically, though, if you’re an employee of an organization, you pay half the FICA taxes owed and your employer pays the other half. So, you would pay 1.45% for Medicare on all your wages plus 6.2% on the first $142,800 for Social Security, while your company would pay the same amounts.
Note: Individuals who make more than $200,000 – or $250,000 if married filing jointly – will pay an additional 0.9 percentage points into Medicare on wage income over the $200,000/$250,000 threshold. Plus they may owe 3.8% in Medicare taxes (2.9% + 0.9%) on some of their investment income, including taxable capital gains, dividends, interest, rental income and annuities.
What is the capital gains tax? When you invest in a stock, mutual fund, house, piece of art, or any other capital asset that may appreciate, you typically have to pay a capital gains tax on the amount the asset has appreciated over time, but only when you sell that asset.
So if you buy a stock at $100 a share and sell it at $125, you will owe tax on the $25 gain.
How much tax you pay is based on three things: your taxable income, how long you’ve held the asset and whether any special rules apply to a given asset – for example, the first $250,000 of gain for individuals who sell a home ($500,000 for married couples) is exempt from the capital gains tax.
Gains on assets held less than a year will be taxed at your ordinary income tax rate.
Gains on assets held more than a year are taxed at 0% if your taxable income is below $80,000; at 15% if your taxable income is at least $80,000 but less than $441,450 if you’re single, or $496,600 if you’re married filing jointly. If you make more than that amount you will pay 20%.
What is a capital loss? Investments can fall in value. When you sell an asset for less than you paid you will incur a capital loss.
That loss can offset dollar-for-dollar the taxable capital gains you made in a given year. But if your loss exceeds your gains that year, you can carry over $3,000 in losses to the next tax year to offset future gains.
But you are not allowed to use the loss from the sale of a home or car to offset any gains you may have on other assets.
What is a tax deduction? A tax deduction reduces your taxable income and that will reduce the taxes you owe by a percent equal to your top income tax rate.
So, for example, if your top income tax rate is 22%, and you claim a $1,000 deduction, that will reduce your final tax bill by $220.
Therefore, the higher your top tax rate the more valuable a deduction will be to you.
What is the standard deduction? It’s a lump sum deduction subtracted from your adjusted gross income. In 2021, the standard deduction is $12,550 for individuals and $25,100 for joint filers.
Most filers take the standard deduction because it offers them a bigger tax benefit than if they itemized all the individual deductions they’re eligible for.
What is a tax credit? It’s a dollar-for-dollar reduction of the taxes you owe.
Some tax credits – like the Earned Income Tax Credit – are also refundable, meaning you may get a bigger refund if the credit alone or in conjunction with other tax credits reduces your income tax liability to less than zero. You would get paid the amount below zero.
What is tax liability? Quite simply, it’s what you owe to the tax man, whether that’s the IRS, or your state and local revenue departments. When you fill out your income tax return, you will be guided through a series of questions and calculations to determine how much, if any remaining tax liability you must pay when you file your return. Or, those calculations may show you’ve paid too much tax and are owed a refund.