A to Z Guide to Taxes – Terms, Definitions & Strategies
Matt is the Lead Editor over at Distilleddollar.com, a personal finance website that I frequent because his info is so on point. He’s also a CPA, which is why I asked him to write this intro guide to taxes. Enjoy!
The first stage to becoming a licensed CPA is typically celebrating with a night out.. I’ll never forget finding out that I had passed my final CPA exam (there are 4 in total with an average pass rate between 40 and 50% for EACH one). My immediate response was to pick up a $100 bottle of scotch. This was a night to celebrate, frugality be damned.
The second stage, which ironically happened that same night, was someone asking me a question about their personal income tax return.
Little did I know, I had signed up for a lifetime of people asking me tax questions.
First Off – Disclaimer
Taxes are complicated and it is never easy to suggest or prescribe any particular course of action without knowing the full set of circumstances. Please, as with anything you read on the internet, verify all and any information you read here and discuss the topics with a tax professional. Your particular set of facts might preclude you from realizing a benefit I discuss below.
I’ve spent years helping individuals file tax returns but I still work collaboratively with other professionals to guarantee the level of work is complete and accurate.
To be clear, all forms of income, and this means ALL, should be included unless they’re specifically excluded. This sentence is what put Al Capone behind bars as he never included his illegal income as part of his gross income. Yes, the IRS doesn’t care how we make the money, but they do want us to report and pay taxes on that income.
Other common examples include rental income, short term capital gains/losses, interest income, and dividend income. Revenue recognition is an area of taxation where things can become extremely complicated, very quickly.
I mentioned interest above and I’ll highlight how not all interest is taxable. If we purchased state and/or local government bonds, then these streams of income are tax exempt. This holds true for funds that hold these bonds.
Another item to note: net capital gains or losses. For gains, there may be a different rate depending on the holding period (generally, one year or more qualifies for long-term rates which are often lower than our marginal rate). For net capital losses, we may be able to adjust our AGI by the amount of the loss, up to $3,000 (last I checked). If our loss is greater than $3,000, then we may be able to carry forward our loss to be taken in future years.
Adjustments are made “above the line” which is another way to say they occur before AGI, adjusted gross income, is determined. Below the line includes deductions and exemptions.
Please note, I’ll begin to detail individual terms. There is a difference between a personal exemption and a deduction or an adjustment so be specific when bringing up these terms to others.
Student loans have their own section below, but these qualify here as adjustments. Contributions made to an HSA, or health savings accounts, also fall into the adjustment category. Other adjustments include IRA’s, work related moving expenses, and tuition and fees deductions.
Do My Student Loans Qualify for Tax Savings?
I’ve heard this question, or some version of it many times by first time filers. In short, yes, we do receive a tax benefit on student loan payments IF we do not have a high AGI (currently, the tax benefit is phased out between AGI of $65,000 and $80,000.) Here’s the IRS publication with more information but I’ll detail some of the main points here.
Standard Deduction vs Itemized Deductions
What Qualifies as an Itemized Deduction?
This gets into many, many details here so I’ll quickly summarize a few that might pique our interest.
Other itemized deductions include charity (up to 50% of our AGI) and medical bills (in excess of 7.5% of AGI).
How Do I Qualify for a Personal Exemption
Why Tax Credits are More Important than Deductions
Tax credits are offset against our tax due whereas deductions reduce AGI. Here’s an example on how credits can be worth many times what a deduction is worth.
If we have a $3,000 tax credit, an AGI of $30,000 and a 33% tax rate, then the tax due is $10,000 with the final due being $7,000.
Can Credits Be Refundable?
One Unique Tax Saving Strategy for Young Professionals
Like many tax savings opportunities, this case only fits a specific type of person so, as usual, the devil is in the details here.
There is a credit called the Retirement Savings Contributions Credit also known as the Saver’s Credit. As mentioned above, a credit can be 10x more beneficial than an adjustment since a credit directly offsets our tax liability.
Should I Be Happy to Receive a Refund Every Year?
One comment I hear from people is that they’re proud to receive a refund every year. They often mention this as if the money all of a sudden becomes theirs when they file their 1040. To clarify, if we receive a tax refund that means we’ve OVERPAID our taxes during the year and the government is returning OUR money back to us.
Some people prefer this method because they insist the alternative would be a complete nightmare. They would rather overpay and receive a refund, than underpay and receive a tax bill. If you can, you should weigh up your tax situation ahead of time to understand where your final tax bill will fall.
I Need More Time – Filing for an Extension
I’m Being Hit with a Tax Penalty – What Should I Do?
If we see we are being assessed with a penalty, first, figure out why. Once we solve the initial issue that created the problem, I would petition our state’s department of revenue or the IRS for a waiver of penalty. This type of waiver is often granted to first time offenders. If we can explain what created the issue in the first place AND demonstrate the actions we have taken to remedy this problem moving forward, the Department will often allow an abatement on our penalty.
I’ve seen first time penalties be waived over a very concise rationale but I’ve rarely seen 2nd time penalties waived.
When Should I Hire a CPA or Tax Professional
My personal route has involved using TurboTax or H&R Block. Their online tax software helped me file my returns in less than an hour, from a cost range of free to ~$50.
I hope after reading this “short” intro, taxes aren’t as mysterious as they used to be. I also hope you walk away with knowledge of some basic terminology and feel more confident asking specific questions.