There are some basic tax terms that are relatively simple, yet confusing all at the same time. Following are some of these terms. You might know them all, but these definitions could help you explain them to a friend who doesn’t get it.
Tax credit vs. tax deduction – Let’s start at the beginning. A tax credit is a dollar-for-dollar reduction in taxes owed – a credit can mean cash. For example, there are refundable tax credits, which give money back even when the amount of the credit exceeds tax liability. Nonrefundable credits only reduce tax liability.
A tax deduction (think charitable donations, job expenses, etc.) only lowers taxable income (decreases how much income will be taxed).
Above-the-line deduction – These deductions don’t require a taxpayer to itemize. When above-the-line deductions are subtracted from total income, the result is adjusted gross income, which is used to calculate tax liability. Generally, itemization is beneficial if total itemized deductions exceed the standard deduction.
Claiming zero allowances vs. claiming exemption from withholding – Most people claim one allowance for themselves and additional allowances for people they claim as dependents. Claiming zero allowances will result in “the most” money being withheld from paychecks, and thus smaller paychecks. As the number of allowances claimed increases, less is withheld from the paycheck and there is more take-home pay.
Whereas claiming exemption from withholding on a W-4 likely means the taxpayer owed no federal taxes last year and anticipates owing no federal income taxes this year. In this case, none – as in zero dollars – will be withheld from the paychecks. If no taxes were deducted and they should have been, a tax bill plus penalties may be due when filing the income tax return.
Capital loss – This is the difference between what was paid for an investment, such as stocks, and the lower cost at which the investment was later sold. Capital losses are tax-deductible up to the amount of capital gains plus $3,000. Any unused capital losses may be carried forward to future years. Capital gains must be reported as income because that money is taxable.
Casualty loss – This is often the result of fire, extreme weather or theft. Casualty losses can be deducted as an itemized deduction. Each loss is reduced by $100, and the total of all losses is then reduced by 10 percent of adjusted gross income.
Hope this cleared up some things. As it goes with many things, there’s bad news and there’s good news. The bad news is that there are hundreds more tax terms out there and the good news is that a tax professional can help you figure out which ones impact you.