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When discussing taxes, reading tax-related articles or instructions, one needs to understand the basic lingo and acronyms used by tax professionals and authors to grasp what they are saying. It can be difficult to understand tax strategies if you are not familiar with the basic terminologies used in taxation. The following provides you with the basic details associated with the most frequently encountered tax terms.
Inflation Adjustments – The standard deductions, tax rates, amounts that can be contributed to retirement plans, virtually all amounts claimed as deductions, and credits are annually adjusted for cost-of-living changes from the prior year or another base year as required by the tax code. Thus, when determining an amount, care should be taken to determine the year-specific amount. The numbers used in this article are for the year 2021.
Filing Status—Generally, if you are married at the end of the tax year, you have three possible filing status options: married filing jointly, married filing separately, or, if you qualify, head of household. If you were unmarried at the end of the year, you would file as single unless you are eligible for the more beneficial head of household status. A special status applies to some widows and widowers.
Head of household is the most complicated filing status to qualify for and is frequently overlooked and incorrectly claimed. Generally, the taxpayer must be unmarried AND:
Pay more than one half of the cost of maintaining their home, a household that was the principal place of abode for more than one half of the year of a qualifying child or certain dependent relatives, or
Pay more than half the cost of maintaining a separate household that was the main home for a dependent parent for the entire year.
A married taxpayer might be considered unmarried to qualify for head of household status if the spouses were separated for at least the last six months of the year. Provided the taxpayer wanting to be eligible for the head of a household status has maintained a home for a dependent child for over half the year.
Surviving spouse (also referred to as qualifying widow or widower) is a rarely used status for a taxpayer whose spouse died in one of the prior two years and who has a dependent child at home. The main benefit of this status is that the widow(er) can use the more favorable married joint tax rates rather than the head of household or single rates. In the year the spouse passed away, the surviving spouse may file jointly with the deceased spouse if not remarried by the end of the year. In rare circumstances, the executor of the decedent's estate may determine that it is better to use the married separate status on the decedent's final return for the year of a spouse's death. Which would then also require the surviving spouse to use the married separate status for that year.
Suppose a taxpayer is married to a non-resident alien. In that case, the taxpayer has two options: file as married separate, reporting only their income, deductions, and credits, or elect to file a joint return with the spouse, including the worldwide income of both of them on a joint return.
Adjusted Gross Income (AGI)—AGI is the acronym for adjusted gross income. AGI is generally the sum of a taxpayer's income less specific subtractions called adjustments (but before certain below-the-line deductions and the standard or itemized deductions). The most common adjustments are penalties paid for early withdrawal from a savings account and deductions for contributing to a traditional IRA or self-employment retirement plan. Many tax benefits and allowances, such as credits, specific adjustments, and some deductions, are limited by the amount of a taxpayer's AGI.
Modified AGI (MAGI)—Modified AGI is AGI (described above) adjusted (generally up) by tax-exempt and tax-excludable income. MAGI is a significant term when income thresholds apply to limit various deductions, adjustments, and credits. The definition of MAGI will vary depending on the item that is being limited.
Taxable Income—Taxable income is AGI fewer deductions (either standard or itemized). Your taxable income is what your regular tax is based upon using a tax rate schedule specific to your filing status. The IRS publishes tax tables based on the tax rate schedules and simplifies the tax calculation. However, you can only use the tables to look up the tax on taxable income up to $99,999. The tables for 2021 have not been released yet, but those for 2020 can be found in the 1040 instructions beginning on page 66.
Marginal Tax Rate (Tax Bracket)—Not all of your income is taxed at the same rate. The amount equal to your standard or itemized deductions is not taxed at all. The next increment is taxed at 10%, then 12%, 22%, etc., until you reach the maximum tax rate, which is currently 37%. When you hear people discussing tax brackets, they are referring to the marginal tax rate. Knowing your marginal rate is important because any increase or decrease in your taxable income will affect your tax at the marginal rate. For example, suppose your marginal rate is 24%, and you can reduce your income by $1,000 by contributing to a deductible retirement plan. You would save $240 in federal tax ($1,000 x 24%). Your marginal tax bracket depends upon your filing status and taxable income. You can find your marginal tax rate for 2021 by using the table below.
Taxpayer & Dependent Exemptions – In the past, taxpayers could qualify for an exemption amount for the filer, spouse filing jointly, and each dependent, which was also subtracted from AGI to determine taxable income. However, from 2018 through 2025, the deduction for exemption amount has been suspended and replaced with a higher standard deduction and child tax credit.
Qualified Child—An eligible child meets the following tests:
(1) Has the same principal place of abode as the taxpayer for more than half of the tax year except for temporary absences;
(2) Is the taxpayer's son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any such individual;
(3) Is younger than the taxpayer;
(4) Did not provide over half of their own support for the tax year;
(5) Is under age 19, or under age 24 in the case of a full-time student, or is permanently and disabled (at any age); and
(6) Was unmarried (or if married, either did not file a joint return or filed jointly only as a claim for refund).
Dependents— Even though there's currently no deduction for dependent exemptions, there are still some significant tax benefits for taxpayers who can claim a dependent. To qualify as a dependent, an individual must be the taxpayer's qualified child or pass all five of the following dependency qualifications: the (1) member of the household or relationship test, (2) gross income test, (3) joint return test, (4) citizenship or residency test, and (5) support test. The gross income test limits the amount an individual can make and still qualify as a dependent if they are over 18 and is not eligible for an exception for certain full-time students. The support test generally requires that you pay over half of the dependent's support. However, there are special rules for divorced parents and situations where several individuals provide over half of the support.
Deductions— A taxpayer generally can choose to itemize deductions or use the standard deduction. The standard deductions are illustrated below.
The standard deduction is increased by multiples of $1,700 for unmarried taxpayers over age 64 and/or blind. For married taxpayers, the additional amount is $1,350. The extra standard deduction amount is not allowed for elderly or blind dependents. Those with significant deductible expenses can itemize their deductions instead of claiming the standard deduction. The standard deduction of a dependent filing their return will often be less than the single amount shown above.
For 2021 only, taxpayers claiming the standard deduction are also allowed to deduct from their AGI up to $300 ($600 for joint filers) of cash contributions made to qualified charitable organizations. Typically, charitable contributions are deductible only when itemizing the deductions described next.
Itemized deductions generally include:
(1) Medical expenses, limited to those that exceed 7.5% of your AGI.
(2) Taxes consist primarily of real property taxes, state income (or sales) tax, and personal property taxes but are limited to a total of $10,000 for the year.
(3) Interest on qualified home acquisition debt and investments; the latter is limited to net investment income (i.e., the deductible interest cannot exceed your investment income after deducting investment expenses).
(4) Charitable contributions are generally limited to 60% of your AGI, but the limit can be as little as 20% or 30% of AGI in certain circumstances. For 2020 and 2021, the limit was increased to 100% of AGI for cash contributions.
(5) Gambling losses to the extent of gambling income and certain other rarely encountered deductions.
Alternative Minimum Tax (AMT)—The AMT is another tax method that has often surprised taxpayers. Even though the AMT was originally intended to ensure that wealthier taxpayers with large write-offs and tax-sheltered investments pay at least a minimum amount of tax, it sometimes snares lower-income taxpayers. Your tax must be computed by the standard method and also by the alternative way. The higher tax must be paid. The following are some of the more frequently encountered factors and differences that make the AMT greater than the regular tax.
The standard deduction is not allowed for the AMT, and a person subject to the AMT cannot itemize for AMT purposes unless they also itemize for regular tax purposes. Therefore, it is crucial to make every effort to itemize if subject to the AMT.
Itemized deductions:
Taxes are not allowed at all for the AMT.
Interest paid for loans to purchase non-conventional homes such as motor homes and boats are not allowed as an AMT deduction but are deductible for regular tax. For years 2018–2025, Interest paid on home equity debt is also not allowed for either AMT everyday tax purposes.
Nontaxable interest from private activity bonds is tax-free for regular tax purposes, but some are taxable for the AMT.
Statutory stock options (incentive stock options), when exercised, produce no income for regular tax purposes. However, the bargain element (difference between the grant price and exercise price) is income for AMT purposes in the year the option is exercised.
Depletion allowance above a taxpayer's basis in the property is not allowed for AMT purposes.
A certain amount of income is exempt from the AMT, but the AMT exemptions are phased out for higher-income taxpayers.
Your tax will be the higher tax computed the traditional way and by the Alternative Minimum Tax. Anticipating when the AMT will affect you is difficult because it usually results from a combination of circumstances. In addition to those items listed above, watch out for transactions involving limited partnerships, depreciation, and business tax credit only allowed against the regular tax. All of these can strongly impact your bottom-line tax and raise a question of possible AMT. Fortunately, fewer taxpayers are paying AMT due to tax reform that increased the AMT exemption amounts and the phaseout thresholds. Tax Tip: If you were subject to the AMT in the prior year, you itemized your deductions on your federal return for the preceding year, and had a state tax refund for that year, part or all of your state income tax refund from that year may not be taxable in the regular tax computation. To the extent that you received no tax benefit from the state tax deduction because of the AMT, that portion of the refund is not included in the subsequent year's income.
Tax Credits—Once your tax is computed, tax credits can reduce the tax further. Credits reduce your tax dollar for dollar and are divided into two categories: those that are nonrefundable and can only offset the tax and those that are refundable. In addition, some credits are not deductible against the AMT, and some credits, when not fully used in a specific tax year, can carry over to succeeding years. Although most credits result from some action taken by the taxpayer, some commonly encountered credits are based simply on the number or type of your dependents or your income. These and other popular credits are outlined below.
Child Tax Credit—Thanks to the American Rescue Plan Act, the child tax credit for one year only (2021) has been increased to $3,000 for a child under age 18 ($3,600 if under age 6), up from $2,000 in 2020. Unlike other years, the credit is fully refundable, and there is no requirement for the taxpayer to have earned income.
The credit has two phaseouts for higher-income taxpayers. Phaseout is $50 for each $1,000 of MAGI above the thresholds. The threshold phases out the increase in child credit for 2021 over $2,000 per child. The first phaseout threshold is $150,000 for married filing joint filers, $112,500 for those filing as head of household, and $75,000 for others. The second phaseout applies to the $2,000 portion of the credit with thresholds of $400,000 for married filing taxpayers and $200,000 for others.
Congress mandated that the IRS estimate this credit for taxpayers based upon their 2020 returns and pay half of the estimated credit in monthly installments beginning July 2021. Taxpayers will need to reconcile the advance payments with the actual credit determined when they complete their 2021 return. Repayment of excess advance amounts may be required depending on AGI.
Dependent Credit – A nonrefundable credit is also available to taxpayers with a dependent who isn't a qualifying child. The $500 dependent credit is not refundable and subject to the second phaseout discussed above for child tax credits.
Earned Income Credit—This is a refundable credit for a low-income taxpayer with income from working either as an employee or a self-employed individual. The credit is based on earned income, the taxpayer's AGI, and the number of qualifying children. A taxpayer who has investment income such as Interest and dividends over $10,000 is ineligible for this credit. The credit was established as an incentive for individuals to obtain employment. It increases with earned income until the maximum credit is achieved and then begins to phase out at higher incomes. The table below illustrates the phaseout ranges for the various combinations of filing status and earned income and the maximum credit available.
Residential Energy-Efficient Property Credit—This credit is generally for energy-producing systems that harness solar, wind, or geothermal energy. This includes solar-electric, solar water-heating, fuel-cell, small wind-energy, and geothermal heat-pump systems. These items currently qualify for a 26% credit with no annual credit limit. Unused residential energy-efficient property credit is generally carried over through 2022. The credit rate reduces to 22% in 2023. The credit expires after 2023.
Withholding and Estimated Taxes—Our "pay-as-you-go" tax system requires that you make payments of your tax liability evenly throughout the year. If you don't, you could owe an underpayment penalty. Some taxpayers meet the "pay-as-you-go" requirements by making quarterly estimated payments. However, when your income is primarily from wages, you usually meet the requirements through wage withholding and rely on your employer's payroll department to take out the right amount of tax, based on the withholding allowances shown on the Form W-4 that you filed with your employer. To avoid potential underpayment penalties, you are required to deposit by payroll withholding or estimated tax payments an amount equal to the lesser of:
1) 90% of the current year's tax liability; or
2) 100% of the prior year's tax liability or, if your AGI exceeds $150,000 ($75,000 for taxpayers filing as married separate), 110% of the prior year's tax liability.
Suppose you had a significant change in income during the year. In that case, we can assist you in projecting your tax liability to maximize the tax benefit and delay paying as much tax as possible before the filing due date.
Please call if this office can be of assistance with your tax planning needs.