Whether you've been filing taxes for years or this season will be the first time you're submitting your own tax return, there might be some tax-related concepts that you tend to mix up. It can happen to the best of us, so there's no need to be embarrassed. In case you need the reminder, here are 10 terms you'll find on tax forms that you won't want to jumble.
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1. Tax Credits and Deductions
In your mind, these terms might be one and the same. Both can reduce your income tax liability, but they're two different concepts.
Tax deductions are subtracted from your taxable income. The impact of your deductions ultimately depends on the marginal tax bracket that you fall into. In other words, let's say you have a $2,000 deduction. If you're in the highest marginal tax bracket (39.6%) that deduction saves you more than it saves someone in a lower tax bracket. That's why tax credits can be more beneficial to lower- and middle-income taxpayers.
Tax credits directly lower your tax bill and their value isn't affected by tax brackets. So a $2,000 tax credit is worth the same ($2,000) to a person in the 15% tax bracket as it is to an individual in the 33% bracket. In addition, if you qualify for a refundable tax credit you could come out ahead at tax time. With a refundable tax credit, the amount of the credit minus the amount you owe the IRS is the money you'll get to keep. Score!
Related Article: What Can You Deduct at Tax Time?
2. Standard and Itemized Deductions
Taxpayers can either itemize their deductions or use the standard deduction on their tax returns. The route you take should depend on whatever lowers your taxable income the most.
The standard deduction is a fixed value that can fluctuate yearly to keep up with inflation. The size of the standard deduction varies based on age, income and filing status. What's great about the standard deduction is that you can reduce your taxable income without having to keep track of a bunch of receipts.
Most people who aren't wealthy will benefit more from the standard deduction than they would if they itemized their deductions. But if you think you'll get more deductions by itemizing you can check your records and add up deductible expenses like your mortgage interest.
3. Allowances and Exemptions
What's the difference between allowances and exemptions? An allowance determines the amount of income you'll have withheld from your paychecks and turned over to the IRS. The more allowances you claim, the less you'll have taken out of your paychecks.
You can claim allowances on your W-4 form for yourself, your spouse and your dependents. The number of jobs you have and the amount of income you're earning also come into play. If you claim too many allowances, you could end up owing extra taxes. When you don't claim enough, you stand to receive a tax refund.
Exemptions are types of deductions that you claim on your income tax return to lower the amount of your money that's taxed. Like allowances, exemptions can be claimed for your children, your husband or wife and for yourself. Income determines who's eligible for personal exemptions. Other exemptions are available for qualifying organizations and businesses.
4. W-2 and W-4 Forms
W-4 forms are what employees fill out when they begin a new job or experience a change that affects their financial status. You use a W-4 form to indicate the amount of tax that needs to be subtracted from your earnings and sent to the government each pay period.
Related Article: A Guide to Filling out Your W-4 Form
In contrast, the W-2 form is what employers prepare for their employees. W-2 forms show workers their total yearly earnings. They also report the amount of taxes that have already been withheld from paychecks and put toward taxes and benefits like Social Security.
5. Earned Income and Adjusted Gross Income
Your gross income is your total income. It's how much you earn from working and investing before you're taxed. It also includes income from child support, alimony, Social Security, unemployment benefits and retirement accounts.
Now, your adjusted gross income (or your net income) is what's left over once you subtract certain deductions from your gross income, including alimony payments you make and moving expenses you incurred when you relocated for a new job. It's important because it's the number used to determine which tax credits you're eligible for and which tax bracket you fall in. Your taxable income is your adjusted gross income minus your exemptions and your itemized or standard deductions.
Earned income, on the other hand, only accounts for certain kinds of taxable income: salaries, wages, bonuses, commissions and net business earnings. It doesn't include government benefits, retirement funds or earnings from dividends and interest. But it does cover benefits from union strikes and long-term disability acquired before the age of 62 (the minimum Social Security retirement age).
Tax forms can be tricky to decipher even if you have their instructions in front of you. But once you can differentiate between some of the commonly used terms, the forms will seem a lot less intimidating.
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