Sharpen up your tax knowledge with a review of key tax terms.
There are things in life you need, and things in life you want. When it comes down to it, life's true necessities can be counted evenly on one hand: Food, water, shelter, income, and a little tax know-how. Make sure that you know these essential tax definitions before the year's out.
Adjusted gross income
Adjusted gross income (AGI) is your total income minus certain tax-deductible items. The income portion of AGI includes things like wages, interest, dividends, alimony received, farm income, and unemployment compensation. The offsetting items are qualified IRA contributions, certain business expenses, interest paid on student loans, alimony payments, higher education expenses, expenses related to health savings accounts, etc. AGI is defined in Section 62 of the Tax Code.
While there are several variations of income listed on your tax return, taxable income is the one that matters most. This is the figure upon which your taxation rate is applied. Taxable income is computed by your AGI minus your "below the line" deductions, which are explained below.
Deductions are the items that reduce your taxable income, either "above the line" or "below the line." Above the line deductions are those items that make up the difference between gross income and AGI. Below the line deductions are subtracted from AGI in the calculation of taxable income. Below the line deductions are further categorized as standard or itemized.
Itemized deductions are specific amounts derived from actual tax-deductible expenses you incurred. To benefit from itemized deductions, you have to elect to itemize, and then list the amounts taken on Schedule A. Examples of itemized deductions are:
- Medical expenses that are greater than 7.5 percent of your AGI
- Qualified mortgage interest expense
- Gambling losses, not to exceed gambling winnings
- Qualified charitable contributions
- State and local taxes paid
- Bad debts
Sections 161 through 199 of the tax code define itemized deductions.
The standard deduction is a set dollar amount that can be used in lieu of listing itemized deductions. Many taxpayers take the standard deduction because it's easier than itemizing; others take it because they don't have a material amount of itemized deductions available to them. Each year, the IRS specifies standard deduction amounts by filing status.
Exemptions are additional items that reduce your taxable income. They are similar to standard deductions, in that they're applied to taxable income in specified dollar amounts. The value of exemptions available to a household depends on the number of people that the household supports. Every taxpayer whose income doesn't exceed set threshold amounts can claim one personal exemption for himself, and one for each of his dependents.
Now that you have your periodic tax lesson out of the way, reward yourself by enjoying some of life's non-essentials, guilt-free.