It can be startling to see terms that you do not recognize, particularly terms applying to taxes. Take a few minutes to familiarize yourself with these common tax terms so that they don’t spook you!
Adjusted gross income (AGI) is the number you add to that very last box on Page 1 of your federal income tax return. AGI is a taxpayer’s income less certain adjustments. A lower AGI is often desirable because AGI affects so many other parts of the tax return, and it is frequently the starting point for state tax returns.
Taxpayers may be spooked when the AGI amount gets too high, which limits deductions and causes taxpayers to be ineligible for certain credits. When taxpayers fear their AGI is at or reaching the “breaking point,” they should consider strategies to lower it by reducing their income (e.g., contributing more money to a 401(k)) or increasing their above-the-line deductions.
2. Above-the-Line Deductions
The “line” here refers to AGI. Above-the-line deductions are not scary at all; in fact, they are typically very beneficial to taxpayers since they lower overall tax liabilities. Below-the-line deductions are buried (perhaps like mummies!), however, and are never to be found again for certain high-income taxpayers or taxpayers who take the standard deduction. Taxpayers should seek guidance to help ensure that they are getting all of the deductions available to them – and to resurrect the possibility of above-the-line deductions.
Alternative minimum tax (AMT) has been frightening taxpayers for more than 40 years. Congress enacted the first individual minimum tax in 1969 to ensure that people it believes should be paying taxes are doing so. If you are looking to conquer your fears of the AMT, then check out our article about navigating AMT and your tax liability.
The term “basis” can seem like a dark, eerie shadow in the corner. But shine a light on that shadow, and that imagined ghoul becomes defined as a taxpayer’s investment in a particular asset. Stocks, rental property, business ownership, and even inherited jewelry all have a basis associated with them. Basis is important because it helps determine the amount of gain or loss that will be taxed if and when the asset is sold. Basically, basis begins at the price the taxpayer paid for the asset and is adjusted for money that the taxpayer contributes toward that asset (such as improvements on rental property) or takes out of the asset (such as a cash distribution from the business).
Tricky rules for inherited or gifted assets sometimes startle taxpayers. To avoid such a fright, be sure to check with your tax professional before exploring unknown territory, such as selling an asset.
5. Refundable and Nonrefundable Credits
More than anything, taxpayers fear a large tax liability, and that is where credits can come in handy. Because credits reduce taxes owed and not just taxable income, they have a greater impact than deductions.
- Refundable Credits: Refundable credits can reduce tax liability below zero dollars. If a taxpayer does fall below zero dollars in liability, the IRS is required to issue the taxpayer a refund check.
- Nonrefundable Credits: Nonrefundable credits can reduce tax liability no lower than zero dollars, meaning the IRS will never be required to provide the taxpayer with a refund check solely due to those nonrefundable credits.
6. After-Tax and Pre-Tax Dollars
“After-tax” and “pre-tax” are two hair-raising terms used in the context of investing. In most cases, taxpayers will report all of their income on the tax return and pay taxes on the full amount.
- After-Tax Dollars: Any cash remaining after taxes are paid is considered “after-tax dollars” that are available to invest. A Roth IRA is an example of an investment that is funded with after-tax dollars.
- Pre-Tax Dollars: Investing with “pre-tax dollars,” such as with a traditional IRA, allows taxpayers to reduce total income on their tax return by the amount they are investing, so they don’t pay any upfront taxes on the amount that was invested.
If taxpayers are scared that they’ll choose the wrong type of investment, then they should contact both their investment advisors and tax advisors for help.
When a small business purchases an asset, the owner(s) either capitalizes or expenses that asset. If an asset is capitalized, a taxpayer will take small deductions each year over a number of years until the full cost of the asset has been deducted. These annual deductions are known as “depreciation.” Alternatively, when a taxpayer expenses an asset, that taxpayer takes a deduction for the full purchase price of that asset in the year it was purchased. Companies should evaluate which expenditures may qualify for expensing versus capitalization to ensure they don’t awaken any IRS goblins as a result.
Choose Treats over Tricks
We hope these explanations have helped take the fright out of the terms above and chased the goblins away. Contact the CRI tax team to discuss these or any other tricky tax questions.