The American tax system works by voluntary compliance. This means that you are responsible for reporting and paying your income tax. It is important that you use deductions and exemptions so you can make sure you are not overpaying on your taxes. In order to only pay the amount your legally owe it is important that you are familiar with the eight terms that we are about to discuss.
Adjusted Gross Income & Taxable Income
Adjusted Gross Income, AGI, is your total income modified that you received from your wages, salaries, capital gains, and dividends. In order to determine your Adjusted Gross Income you are going to have to subtract your deductions from your income total such as IRA contributions, moving costs, business expense, and alimony. The Adjusted Gross Income is very important because it determines how much you can claim on your itemized deductions. Furthermore, majority of the states calculate taxation amounts based on your Adjusted Gross Income.
Taxable income on the other hand is the most relevant number that is found on your tax return. This is because your taxable income determines the amount of taxes that you will have to pay the government. Furthermore, deductions, exemptions, and anything else that can lower your AGI goes to your taxable income. The results result in lower taxes and possibly a bigger refund.
Standard Deduction, Itemized Deduction & Exemptions
If you use your deductions and exemptions properly you will find you will be able to lower the amount that you owe in taxes. The two main deduction categories are itemized deductions and standard deductions. The standard deduction stays the same for everyone and is determined by the IRS. The amount is going to vary based on the filing status you choose to go with and it also adjusted regularly for inflation. Standard deductions are subtracted from your AGI.
If you do not want to go with the standard deduction your alternative choice is itemized deductions. However, doing so you can expect to spend longer on your taxes yet in can result in you saving more especially if you have large deductions such as mortgage interest. So, when you compare your taxes using standard and itemized deduction if the itemized deductions are more than the standard deduction it is best to go with the itemized deductions.
Common Itemized Deductions
Excess Medical Expenses
Non-reimbursed Employee Expenses
State, Property, and Local Taxes
One you have subtracted your deductions from the AGI you will be able to lower your AGI even more by using exemptions. Exemptions work in the same manner as deductions but they symbolize a different expense. However, they differ from deductions because they are going to remain the same value despite the file status used. But, like deductions, exemption can change each year.
Credits can be more effective when it comes to lowering your taxes than deductions. This is because they provide you with a dollar for dollar offset rather than deduct the amount of taxable income. For example, if you owe $1000 to the IRS but get a $600 tax credit you would owe the IRS $400. If it was a $600 deduction you would save maybe $60 because it just reduces your taxable income. Also, some of the tax credits available, such as the Earned Income Credit, is refundable. This means that if you have a credit that is larger than the amount you owe the IRS they will send you a refund check.
The filing status is what determined your tax bracket. You can file as: single, head of household, married filing jointly, married filing separately or qualifying widow(er) with dependent child.
When selecting your status you must go with the one that is applicable to you. Sometimes there may be more than one option. For example, married couples have two options yet in most cases it is better for married couples to file jointly.
Withholding is when you pay taxes directly to the IRS as your income is earned. Your employer would set up your paycheck so a certain amount of tax is withheld every period. This eliminates you having to make the payments yourself. If you do not make the payments the IRS will penalize you when you file your return since they like to use the pay-as-you-go method.
If you over pay on your withholding taxes you will get a refund back at the end of the year. Some people find it tempting to overpay so they can get a large refund at the end of the year but this is not always wise. All you are doing is giving the IRS an interest free loan. Here is a calculator you can use to see how much you should have withheld. The best thing to do is to put the money aside in an account and earn interest on it. Then, at the end of the year you could get the rush of having a large amount of money that has had interest added on to it.