30 tax terms for understanding taxation in USA 2023

30 tax terms for understanding taxation in the USA 2023

Understanding Taxation

IRS (Internal Revenue Service):- The Internal Revenue Service (IRS) is the primary agency responsible for enforcing and administering the tax laws in the United States. It operates under the Department of the Treasury and oversees the collection of federal taxes, including income tax, payroll tax, and corporate tax. The IRS ensures that individuals, businesses, and other entities comply with tax laws and regulations by filing accurate and timely tax returns and paying the appropriate amount of taxes.

Key responsibilities of the IRS include:

Tax Collection: The IRS collects various types of taxes, including income tax, Social Security tax, Medicare tax, and excise taxes.

Tax Enforcement: The agency enforces tax laws by investigating cases of tax evasion, fraud, and non-compliance.

Taxpayer Services: The IRS provides information, assistance, and resources to help taxpayers understand their rights and responsibilities when it comes to taxes.

Issuing Tax Forms: The IRS creates and distributes tax forms that taxpayers use to report their income and claim deductions and credits.

Processing Returns: The agency processes tax returns and refunds, reviewing the accuracy of information provided and calculating the amount of tax owed or refunded.

Audits: The IRS conducts audits to ensure that tax returns are accurate and compliant with tax laws.

Taxpayer Education: The IRS educates taxpayers about changes to tax laws, deductions, credits, and other relevant topics through various communication channels.

Offering Payment Options: The IRS offers various payment options, including installment agreements, for taxpayers who are unable to pay their taxes in full immediately.

Taxpayer Assistance Centers: These centers provide in-person assistance to taxpayers in resolving issues related to their tax obligations.

Overall, the IRS plays a major role in the functioning of the U.S. tax system, helping to fund government operations through the collection of taxes and ensuring that tax laws are applied fairly and consistently.

Taxpayer Identification Number (TIN):- A Taxpayer Identification Number (TIN) is a unique identification number assigned to individuals, businesses, and other entities for tax purposes in the United States. TINs are used by the Internal Revenue Service (IRS) to track and process tax-related activities, including filing tax returns, paying taxes, and receiving tax refunds. There are different types of TINs, each designed for specific situations:

Social Security Number (SSN): This is the most common type of TIN and is assigned to individuals for various purposes, including employment, tax filing, and government benefits. SSNs are typically used by U.S. citizens and permanent residents.

Employer Identification Number (EIN): Also known as a Federal Employer Identification Number (FEIN), an EIN is assigned to businesses and organizations for tax-related purposes, such as filing business tax returns, hiring employees, and opening business bank accounts.

Individual Taxpayer Identification Number (ITIN): An ITIN is issued by the IRS to individuals who are not eligible for a Social Security Number but need to meet tax obligations, such as filing tax returns. This includes nonresident aliens, certain dependents, and individuals without work authorization in the U.S.

Adoption Taxpayer Identification Number (ATIN): An ATIN is a temporary TIN assigned to children in the process of being adopted when the adoptive parents do not have a valid SSN or ITIN for the child. It is used for tax reporting until the adoption is finalized.

Preparer Taxpayer Identification Number (PTIN): A PTIN is used by tax return preparers who are required to have a unique identification number when preparing and signing tax returns on behalf of clients.

TINs are essential for various financial transactions, tax reporting, and other interactions with government agencies. They help ensure accurate tax reporting and prevent identity theft by providing a unique identifier for each taxpayer.

W-2 Form:- A W-2 form, also known as the "Wage and Tax Statement," is a crucial tax document issued by employers in the United States to their employees. The form provides detailed information about an employee's wages, salary, and tax withholdings for the previous calendar year. It is used by employees to prepare their individual income tax returns and report their income to the Internal Revenue Service (IRS).

Key information found on a W-2 form includes:

Employee Information: This section includes the employee's name, Social Security Number (SSN), and address.

Employer Information: The employer's name, address, and Employer Identification Number (EIN) are listed.

Wages and Compensation: This section shows the total wages earned by the employee during the tax year, including regular salary, overtime pay, and any bonuses or commissions.

Tax Withholdings: The W-2 form displays the amount of federal income tax, Social Security tax, Medicare tax, and any state and local income taxes that were withheld from the employee's paychecks throughout the year.

Dependent Care Benefits: If the employer provides dependent care benefits, such as childcare assistance, the value of these benefits is reported on the form.

Retirement Contributions: Contributions made to retirement plans, such as a 401(k), are often listed on the W-2 form.

Other Compensation: If the employee received any additional compensation, such as tips or certain fringe benefits, these may be included on the W-2.

Employees use the information on the W-2 form to complete their individual income tax returns (typically using Form 1040) and calculate their tax liability or refund. The form is also used to verify the accuracy of tax withholdings and ensure that the correct amount of taxes was remitted to the IRS throughout the year. Employers are required to provide employees with their W-2 forms by January 31st of each year, allowing sufficient time for employees to file their tax returns before the April tax filing deadline.

1040 Form:- The 1040 form, officially known as "Form 1040, U.S. Individual Income Tax Return," is the primary document used by individuals in the United States to report their income and calculate their federal income tax liability. It's a crucial component of the annual tax filing process and is submitted to the Internal Revenue Service (IRS) by taxpayers.

Key sections and components of the Form 1040 include:

Personal Information: The form starts with basic personal details such as the taxpayer's name, Social Security Number (SSN), filing status, and address.

Income: This section requires taxpayers to report all sources of income, including wages, self-employment income, rental income, investment income (such as dividends and interest), and more.

Adjusted Gross Income (AGI): AGI is calculated by subtracting certain deductions, such as educator expenses, student loan interest, and IRA contributions, from the total income. AGI is a very important figure i.e. determines eligibility for specific deductions and credits.

Tax and Credits: Here, taxpayers calculate their federal income tax liability based on their AGI and applicable tax rates. Tax credits, such as the Child Tax Credit or Earned Income Tax Credit, are then subtracted from the tax amount to reduce the overall tax liability.

Payments and Refundable Credits: Taxpayers report any tax payments made throughout the year, including tax withholding from paychecks and estimated tax payments. They also report refundable credits, which can potentially result in a refund even if no taxes were owed.

Other Taxes: This section includes any additional taxes owed, such as the Additional Medicare Tax or the Net Investment Income Tax.

Other Information: Taxpayers may need to provide supplemental information, such as foreign bank account reporting (FBAR) and Health Savings Account (HSA) contributions.

Signature: The form must be signed and dated by the taxpayer, certifying that the information provided is accurate and complete.

The Form 1040 comes in various versions, including the standard 1040 form, Form 1040A (shorter version with fewer itemized deductions), and Form 1040EZ (the simplest version for taxpayers with basic tax situations). However, as of tax year 2018, the IRS has introduced a redesigned Form 1040, which consolidates these versions into one main form with additional schedules for reporting various types of income and deductions.

The specific version of Form 1040 to be used depends on the taxpayer's financial situation and any changes to tax laws in a given tax year.

Taxable Income:- Taxable income refers to the portion of an individual's or entity's earnings that is subject to taxation by a government authority. It is calculated by subtracting allowable deductions, exemptions, and credits from total income. Taxable income is a key factor in determining the amount of income tax owed to the government. Deductions can include business expenses, mortgage interest, and certain contributions to retirement accounts. Exemptions are often associated with dependents. Once deductions and exemptions are subtracted from total income, the resulting figure is the taxable income. Different tax rates are applied to different levels of taxable income, with higher rates typically applied to higher income levels in progressive tax systems. Accurately calculating taxable income is crucial for complying with tax laws and ensuring proper tax payments or refunds.

Tax Deductions:- Tax deductions are allowable expenses that taxpayers can subtract from their total income to reduce their taxable income, ultimately lowering their tax liability. Deductions are a way to recognize certain costs or expenditures that taxpayers incur during the year and that the government considers eligible for tax relief. Common deductions include expenses related to business activities, education, healthcare, home ownership (such as mortgage interest and property taxes), charitable donations, and certain job-related costs. Taxpayers can choose between claiming the standard deduction—a fixed amount set by the government—or itemizing deductions, where they list and provide evidence of specific qualifying expenses. Choosing the method that yields the greatest deduction amount is beneficial, as it directly impacts the taxable income and, consequently, the amount of taxes owed. Understanding available deductions and keeping accurate records of eligible expenses can help individuals and businesses minimize their tax burden legally.

Standard Deduction:- The standard deduction is a fixed amount set by the government that taxpayers can deduct from their total income to determine their taxable income. It serves as an alternative to itemizing individual deductions, simplifying the tax filing process for many individuals. The standard deduction reduces a taxpayer's taxable income without the need to provide documentation for specific expenses.

The amount of the standard deduction varies based on filing status and can change from year to year due to inflation adjustments. It's designed to provide a basic level of tax relief to all taxpayers. Filing status categories include single, married filing jointly, head of household, and more, each with its own associated standard deduction amount. Taxpayers usually choose between taking the standard deduction or itemizing deductions based on whichever option results in a lower taxable income and, subsequently, a lower tax liability. Individuals with fewer qualifying deductions or those seeking a simpler tax filing process often benefit from taking the standard deduction. However, taxpayers with significant deductible expenses, such as high medical costs, mortgage interest, etc.

Itemized Deductions:- Itemized deductions are specific eligible expenses that taxpayers can subtract from their total income to reduce their taxable income, thus potentially lowering their tax liability. Unlike the standard deduction, which offers a fixed deduction amount, itemizing deductions requires taxpayers to list and provide evidence of each qualifying expense individually. Common itemized deductions include medical expenses, state and local taxes, mortgage interest, property taxes, charitable donations, and certain job-related expenses.

Itemizing deductions is beneficial when the total of eligible expenses exceeds the standard deduction amount, as it can lead to a lower taxable income and a potentially reduced tax liability. However, the process is more complex and requires maintaining accurate records and receipts. Taxpayers must choose between taking the standard deduction or itemizing, selecting the option that provides the greatest tax benefit. It's important to note that tax laws and deduction limits may change from year to year, impacting the choice between standard and itemized deductions.

Tax Credits:- Tax credits are direct reductions in the amount of taxes owed to a government authority. Unlike deductions, which lower taxable income, tax credits directly subtract from the final tax liability. Taxpayers can claim credits for various reasons, such as having children (Child Tax Credit), pursuing higher education (American Opportunity Credit), or adopting a child (Adoption Credit). Refundable credits, like the Earned Income Tax Credit, can result in a refund even if the credit exceeds the tax owed. Tax credits offer substantial financial relief and incentivize specific behaviors by providing financial incentives to eligible taxpayers.

Marginal Tax Rate:- The marginal tax rate is the tax percentage applied to an additional unit of income earned. It's the rate at which the next dollar earned is taxed. In progressive tax systems, higher income levels often correspond to higher tax rates. As a taxpayer's income increases, they move through different tax brackets, with each bracket having a different marginal tax rate. Marginal tax rates reflect how additional earnings impact the overall tax liability. Understanding marginal tax rates is vital for effective tax planning, as they help individuals predict how changes in income could affect their taxes and make informed decisions about financial strategies and decisions.

Progressive Taxation:- Progressive taxation is a tax system where the tax rate increases as the taxable income or financial wealth of an individual or entity rises. In this system, higher-income individuals pay a larger proportion of their income in taxes compared to those with lower incomes. Progressive taxation aims to distribute the tax burden more equitably, with the wealthiest individuals contributing a larger share of revenue to fund government programs and services. This approach is often used to address income inequality and provide social services to those in need. It is a fundamental characteristic of many modern tax systems worldwide.

Taxable Estate:- A taxable estate refers to the total value of a deceased individual's assets and property that is subject to federal estate tax upon their death. The estate tax is levied on the transfer of assets from the deceased person's estate to their heirs or beneficiaries. It includes assets such as real estate, investments, cash, and personal property. There is an estate tax exemption amount, which is the threshold below which an estate is not subject to taxation. Estates exceeding this threshold are subject to taxation at a progressive rate. Proper estate planning can help individuals reduce the impact of estate taxes on their heirs and beneficiaries.

Gift Tax:- Gift tax is levied on the transfer of assets or money from one individual to another without an exchange of equal value. It aims to prevent wealth redistribution through tax-free gifts. Generally paid by the donor, it has an annual exemption limit up to which gifts are tax-free. If gifts exceed this limit, the donor may need to file a gift tax return. The tax may be applied to the excess amount, but a lifetime exemption allows individuals to give a certain total amount tax-free. Complex regulations surround gift tax, and they vary by jurisdiction. Consulting local tax authorities is advisable for accurate information.

Capital Gains Tax:- Capital gains tax is a tax imposed on the profit earned from the sale or disposal of certain assets, such as real estate, stocks, or other investments. It's calculated based on the difference between the sale price of the asset and its original purchase price (the capital gain). Short-term capital gains, from assets held for a year or less, are usually taxed at a higher rate than long-term gains, from assets held for more than a year. Some jurisdictions offer exemptions or reduced rates for specific types of assets or under certain conditions. Capital gains tax aims to generate revenue and discourage short-term trading while encouraging long-term investments.

Alternative Minimum Tax (AMT):-The Alternative Minimum Tax (AMT) is an additional tax calculation in some tax systems, including the U.S. It ensures that high-income individuals with significant deductions still pay a minimum amount of tax. AMT recalculates taxable income by disallowing certain deductions and exemptions. If the calculated AMT is higher than the regular income tax, the taxpayer must pay the difference. AMT primarily affects individuals with substantial itemized deductions, investment income, or employee stock options. Its purpose is to prevent wealthy taxpayers from exploiting loopholes to avoid paying a fair share of taxes, ensuring a baseline level of taxation.

Filing Status:- Filing status refers to the classification an individual uses on their tax return to determine their tax liability. Common filing statuses in the U.S. include "Single," "Married Filing Jointly," "Married Filing Separately," "Head of Household," and "Qualifying Widow(er) with Dependent Child." Choosing the appropriate filing status is crucial, as it affects tax rates, deductions, and credits. It's determined by factors such as marital status, household composition, and financial situation. Selecting the correct filing status ensures accurate tax calculations and helps taxpayers receive the maximum benefits available under the tax code.

Tax Exemptions:- Tax exemptions are deductions or allowances that reduce a taxpayer's taxable income, thereby lowering their overall tax liability. These exemptions can be claimed for various reasons, such as having dependents, being blind, or being a senior citizen. However, tax exemption rules vary by jurisdiction and can change over time. For instance, in the U.S., as of my last knowledge update in September 2021, tax exemptions were a significant part of the tax code, but they were largely eliminated by the Tax Cuts and Jobs Act of 2017, which increased the standard deduction instead. It's important to consult the most recent tax regulations in your jurisdiction for accurate information on tax exemptions.

Dependent:- A dependent is an individual, typically a family member, who relies on another person for financial support. In tax contexts, dependents play a crucial role as they can lead to various tax benefits for the person providing the support. Tax laws often allow taxpayers to claim dependents on their tax returns, which can result in deductions or credits that reduce the taxpayer's overall tax liability. Dependents can include children, parents, or other relatives who meet specific criteria, such as living with the taxpayer for a certain period and receiving more than half of their financial support from the taxpayer. The rules for claiming dependents vary by jurisdiction and change over time, so it's important to consult the latest tax regulations for accurate information.

Tax Withholding:- Tax withholding is a system where an employer deducts a portion of an employee's wages or salary to remit it directly to the government as an advance payment of the employee's income tax liability. The withheld amount is based on the employee's income, filing status, and the number of allowances claimed on their Form W-4 (in the U.S.). This system ensures that individuals pay their taxes gradually throughout the year, rather than in a lump sum during tax season. Tax withholding helps governments collect revenue efficiently and reduces the likelihood of taxpayers owing significant amounts at the end of the tax year.

Tax Bracket:- A tax bracket is a range of income levels to which a specific tax rate applies within a progressive tax system. As an individual's income increases, they move into higher tax brackets with higher tax rates. The tax system aims to apply higher rates to higher earners, ensuring a fair distribution of the tax burden. In such systems, only the income within each bracket is taxed at the corresponding rate, not the entire income. For instance, if the tax brackets are 10%, 20%, and 30%, and an individual's income falls into the 20% bracket, only the portion of income within that range is taxed at 20%, while the rest remains taxed at lower rates. Understanding tax brackets helps individuals plan their finances and make informed decisions to minimize their tax liability.

Earned Income Tax Credit (EITC):- The Earned Income Tax Credit (EITC) is a tax benefit designed to provide financial support to low and moderate-income individuals and families. It's primarily available in the United States. The EITC functions as a refundable tax credit, meaning that if the credit exceeds the amount of taxes owed, the taxpayer receives the excess as a refund.

The EITC amount is determined based on factors such as earned income, filing status, and the number of qualifying children. Generally, as earned income increases, the credit increases until it reaches a maximum amount. The credit then phases out gradually as income continues to rise beyond a certain threshold.

The EITC serves as a form of social support, aimed at incentivizing work and assisting individuals with limited income. It has the potential to significantly reduce tax liability for eligible taxpayers and can provide a meaningful financial boost for those who qualify.

Social Security Tax:- The Social Security tax, often referred to as the FICA tax (Federal Insurance Contributions Act tax), is a payroll tax in the United States that funds the Social Security program. It's intended to provide financial support to retired and disabled individuals, as well as survivors of deceased workers. Both employees and employers are subject to this tax, with each contributing an equal portion.

As of my last knowledge update in September 2021, the Social Security tax rate was 6.2% for both employees and employers, up to a certain income limit. This means that a total of 12.4% of an individual's earned income was dedicated to Social Security, but only up to a certain income cap. Any income beyond that cap was not subject to Social Security tax.

Self-employed individuals pay both the employee and employer portions of the Social Security tax, resulting in a total of 12.4% of their net earnings.

It's important to note that tax rates and income limits can change over time, so consulting the latest information from the IRS or a tax professional is advisable.

Medicare Tax:- Medicare tax is a payroll tax in the United States that funds the Medicare program, which provides health insurance coverage primarily to individuals aged 65 and older, as well as certain individuals with disabilities. Similar to Social Security tax, Medicare tax is a part of the FICA tax (Federal Insurance Contributions Act tax).

As of my last update in September 2021, the Medicare tax is composed of two parts:

Medicare Hospital Insurance (HI) Tax: This is commonly known as the Medicare Part A tax. Both employees and employers contribute to this tax, with each paying 1.45% of the employee's wages. Unlike Social Security tax, there is no income limit for this tax; it's applied to all earned income.

Additional Medicare Tax: This applies to higher-income individuals. If an employee's wages exceed a certain threshold, which was $200,000 for individuals and $250,000 for married couples filing jointly in 2021, they are subject to an additional 0.9% Medicare tax on the amount exceeding the threshold. Employers do not match this additional tax.

Self-employed individuals are responsible for both the employer and employee portions of the Medicare tax, including the additional Medicare tax if applicable.

Please note that tax laws can change, and it's essential to verify the most recent information from the IRS or a tax professional.

Self-Employment Tax:- Self-employment tax is a tax that self-employed individuals in the United States are required to pay to fund Social Security and Medicare programs. Since self-employed individuals don't have employers withholding Social Security and Medicare taxes from their paychecks, the self-employment tax covers both the employee and employer portions of these taxes.

As of my last update in September 2021, the self-employment tax rate is 15.3% of your net earnings from self-employment. This includes:

12.4% for Social Security: This covers the same Social Security tax rate as employees pay, but since self-employed individuals don't have an employer to share this cost, they pay the full 12.4%.

2.9% for Medicare: This is equivalent to the combined employee and employer Medicare tax rate. Self-employed individuals are accountable for both the employee and employer portions.

In addition to these components, if your net earnings exceed a certain threshold, you might also be subject to an Additional Medicare Tax of 0.9%, which applies to higher-income individuals.

You can deduct the employer-equivalent portion of your self-employment tax when calculating your adjusted gross income, which can provide some relief. It's important to keep accurate records of your earnings and expenses as a self-employed individual to calculate your self-employment tax correctly. Please note that tax regulations can change, so consulting the latest information from the IRS or a tax professional is recommended.

Qualified Retirement Plans:- Qualified retirement plans are tax-advantaged savings accounts established by employers or self-employed individuals to help individuals save for retirement. These plans comply with specific requirements set by the Internal Revenue Service (IRS) to qualify for tax benefits. Examples of qualified retirement plans in the United States include 401(k) plans, individual retirement accounts (IRAs), and pension plans.

Contributions to these plans are typically tax-deductible, meaning that the money contributed is not immediately subject to income tax. Instead, it grows tax-deferred until withdrawal, usually during retirement. This tax deferral can lead to potential growth over time.

However, withdrawals from qualified retirement plans are usually taxed as ordinary income in the year they're taken out. Additionally, there might be penalties for early withdrawals made before a certain age, typically 59½.

Qualified retirement plans provide individuals with an effective way to save for retirement while receiving tax benefits, helping them secure their financial future. The rules and regulations for these plans can vary, so it's essential to understand the specifics of the plan you're considering and consult a financial advisor or tax professional for guidance.

Taxable Interest:- Taxable interest refers to the income earned from various financial instruments, such as savings accounts, certificates of deposit (CDs), bonds, and certain types of loans. This interest income is subject to taxation by the government.

When you earn interest from these investments, it's generally considered part of your taxable income. This means you'll need to report it on your tax return and potentially pay income tax on the interest you've earned. The tax rate applied to your taxable interest depends on your overall income, your tax filing status, and the current tax laws in your jurisdiction.

It's crucial to recognize that not every interest income is subject to taxation.

For instance, interest earned on municipal bonds issued by state or local governments is typically tax-exempt at the federal level and often at the state level as well. Additionally, interest earned in certain retirement accounts like Roth IRAs may also be tax-free if certain conditions are met.

Always refer to the tax regulations in your country or consult a tax professional to understand how taxable interest should be reported and taxed based on your specific financial situation.

Adjusted Gross Income (AGI):- Adjusted Gross Income (AGI) is a key financial metric used in tax calculations. It's the total income an individual reports on their tax return after subtracting specific deductions, such as contributions to retirement accounts and student loan interest. AGI provides a clearer picture of a taxpayer's financial situation, serving as the starting point for determining taxable income. Various tax credits, deductions, and eligibility for certain benefits are based on AGI. By adjusting for allowable deductions, AGI reflects a more accurate representation of an individual's income that affects their tax liability and financial eligibility for different programs.

Tax Liability:- Tax liability refers to the legal obligation an individual or entity has to pay taxes to the government. It's the amount of tax that is owed based on their income, financial transactions, and other taxable activities. Tax liability can vary widely based on factors such as income level, filing status, deductions, credits, and the specific tax laws of the jurisdiction.

Taxpayers calculate their tax liability by applying the appropriate tax rates to their taxable income, after accounting for any deductions and credits. If the amount of tax withheld or paid throughout the year is less than the calculated tax liability, the taxpayer will owe additional taxes. Conversely, if the amount paid is more than the actual tax liability, a refund may be issued. It's important to accurately calculate and fulfill tax liability to comply with tax laws and avoid penalties.

Tax Audit:- A tax audit is a thorough examination and review of an individual's or business entity's financial records, transactions, and other relevant documents by tax authorities, such as the Internal Revenue Service (IRS) in the United States. The purpose of a tax audit is to verify the accuracy and completeness of the information reported on a tax return, ensuring compliance with tax laws and regulations.

Tax audits can be triggered by various factors, such as discrepancies in reported income, unusually high deductions, or random selection. During an audit, taxpayers may be required to provide documentation and explanations to support their reported information. The audit process aims to determine whether the taxpayer owes additional taxes, deserves a refund, or if their reported information is accurate as filed.

It's important to approach a tax audit with transparency, and organized records, and, if necessary, seek assistance from tax professionals to ensure a smooth process and accurate resolution.

Tax Refund:- A tax refund is a repayment of excess taxes that a taxpayer has paid to the government, typically during a tax year. It occurs when the total amount of taxes withheld or paid throughout the year exceeds the taxpayer's actual tax liability as determined by their tax return. Tax refunds can result from various factors, such as over-withholding from paychecks, tax credits, and deductions.

Once a tax return is filed and processed, if the calculations show that the taxpayer has overpaid their taxes, they are eligible to receive a refund for the excess amount. The refund can be received through a check, direct deposit into a bank account, or applied to the following year's tax liability. Many individuals view tax refunds as a form of savings or a way to fund large expenses.