Common Tax Definitions and Related Terms: Taxes 101
April 15 is a stressful day for many people. Taxes are not something that people typically enjoy talking about. I have found that the major reason for this is that people do not fully understand taxes and how they work. If people had a better understanding, they would not be so nervous at tax time. They would also be able to take steps throughout the year so they would not feel like they are being put through the wringer when they do their taxes.
When you take proactive measures to make sure you are paying the right amount of taxes throughout the year, it will not cause you as much stress when you file taxes. In an effort to help you during tax season, please continue reading to find out more about common tax definitions.
When discussing common tax definitions, it is important that we begin with a basic understanding of taxes.
What Are Taxes?
I think on some level, we all understand that taxes are something we have to pay at various points of our lives. There is so much more to taxes than that. It is helpful that you become a bit more familiar with what taxes really are and what is done with your money. When you are more familiar with the way taxes work, you are less likely to make mistakes that cost you a lot of money at tax time. Most people think the Internal Revenue Service (IRS) is this mean overlord just waiting for us all to mess up. They really are not. If you are willing to pay your taxes, they are willing to work with you.
The government, both federal and state, levy a financial charge upon business and individuals for various reasons. Tax is levied upon income, activity, luxuries, property, and privilege of the business or individual person. If you do not pay your taxes, you may be fined or arrested. You are legally bound to pay taxes. The money that is paid out as a result of taxes is used for various activities in the state or country.
Where Tax Money Goes?
A large portion of taxes goes to the defense of the country by spending over $900 billion in support of Homeland Security and Veterans Affairs. There are many other government agencies funded by your taxes, those are just two examples of how your tax money works. Every time you pay taxes, remember something much bigger than just you is at work. Your money is put into a fund where it works in many ways for you.
Different Types of Taxes
Now that I have given you just a little bit of information about what happens with your taxes, now let us talk about all the different types of taxes. Of course, there is not just one tax. You end up paying taxes on many items. Some of which you may not be aware of at all. It is important to understand all of the different types of taxes to which you are subject when you are thinking about common tax definitions. You cannot use the excuse that you did not know as a reason for not paying appropriate taxes. The IRS always finds out and they will come after you for not paying taxes.
Federal, State, And Local Taxes
Depending on where you live and work, you may have to pay all three. You always have to pay federal taxes, no matter where you live and work. If you live in one state, but work in another, you may have to pay taxes for both states. Some states are reciprocal states which means that the two states have an agreement and you only have to pay the taxes in one state. You may only have to pay local or city taxes if you live or work in a city. It is important that you understand which taxes fall under your responsibility.
There are many other taxes you have to pay. I am listing some of the more common ones below:
Personal Income Taxes
Income taxes are a tax that is imposed based on the income that you receive. There are many forms of income. Any money you receive from wages, investments, commissions, and salary. You must file an income tax return every year to ensure you have met your tax obligation.
As mentioned above, this is a large source of revenue for federal, state, and local governments. It is important to understand the common tax definitions around income tax. There are a series of deductions and withholdings that impact how much tax you have to pay. I explain the common tax definitions of those terms later in this article.
Some of your income may be considered non-taxable income. Items such as child support and welfare benefits are some of the income that is not considered taxable. There are tax brackets that determine how much tax you might have to pay. The tax brackets are marginalized, which means depending on where you fall in the tax bracket dictates the percentage you have to pay. The higher your income is, it means the higher you are in the tax bracket and the higher the percentage that you pay in taxes. There are calculators that you can find online that can help give you an indication of how much you have to pay in income taxes.
Business Taxes
Business taxes are similar to personal income tax in that you must pay taxes on the income that your business makes. You also have to file a tax return on an annual basis. That is probably where the similarities end between personal and business income taxes. It is important to understand the common tax definitions as it relates to business taxes. There are separate forms and requirements that you must adhere to when you have business income. Depending on the type of business you have that dictates the type of forms that you are required to file.
Sole proprietorship
If your business is a sole proprietorship that means you are solely responsible for handling all business decisions. It means that you are in control and responsible for all gains and losses. It also means that you benefit from all the profits of the business. Your business income is taxed at the same rate as your personal income. However, as a business, you are eligible for different deductions, which I will talk about later in the article. As a sole proprietor, you are able to deduct 20 percent of your taxable income from your business. That means that it reduces the amount of income that is considered taxable.
Partnership, Corporation, or S Corporation
If you have any of these, you also have different tax implications to handle. You should have your taxes handled by a tax accountant in those cases. There are too many ways you can go wrong or items you can miss that might get you in trouble with the IRS that you should let a professional handle it.
Property Taxes
Another one of the important common tax definitions is property taxes. This type of taxes are the oldest taxes in existence. You must pay them on land, homes, and commercial real estate. The money that you pay in taxes often goes to maintaining roads, schools, drinking water, and sewage treatment in the local area. Whenever you buy a home, you have to pay property taxes.
It is important that you make sure that you can pay the property taxes for the home because that is part of your responsibility. Some areas have an incredibly high property tax and as a result, the area in which they live is really nice. However, if you cannot afford it, you should consider purchasing a home in a different area. You are able to claim property taxes as a deduction on your federal tax return.
Part of Mortgage Payment
Most of the time, your property taxes are part of your mortgage payment. When you pay your mortgage, that bank holds a certain amount aside in escrow to pay the taxes. When your property tax goes up, so does your mortgage payment. If you do not want the money to come directly from your mortgage payment, you can make out a check once a year or every six months for the tax. If you pay it from your mortgage, the tax amount is divided over 12 months, so you pay less at one time. This often makes it easier to make the payments.
Estate Taxes
Another one of the important common tax definitions is estate taxes. This is something you will not have to pay on a regular basis but should be aware of because if you are not, it will hit you hard. An estate tax is something that you pay after someone has died. The taxes are on the net worth of the deceased.
You are taxed for the privilege of receiving money from someone that has passed away. There are ways to decrease this tax but the estate has to be handled and structured in a specific way. An estate tax professional is the best one to help you with this process.
Sales Taxes
Sales tax is also important to mention because it is a tax that you pay on items you purchase. You pay this tax every time you purchase specific items. You do not pay this tax again when you file your tax return. This is often referred to as a consumption tax. It is called that because the more you consume, or purchase, the more tax you pay.
Sales tax is determined based on the sales price of each item. The percentage of tax you pay is based on the state in which you live, as each state is allowed to set their sales tax percentage. Some states do not have sales tax at all.
Excise Taxes
This tax is what you pay when you purchase specific items. The only way to avoid this tax is to not buy the specific items that are taxable. This tax is sometimes referred to as a luxury tax because these are often considered luxury items. You do not need to spend money on these items. Items that routinely fall into this tax are alcohol, tobacco, and lottery, just to name a few.
Important Terms To Know
There are some other common tax definitions that you need to understand before you file your tax returns. When you understand these common tax definitions, it makes it easier for you to make decisions throughout the year that make it easier to file your taxes. Any tax tips that you know when it comes to filing taxes are helpful to you.
There is always great debate over whether or not it is better to get a large refund, owe money to IRS, or come as close as possible to breaking even. While there are many different schools of thought on this topic, the best answer is the one that fits your life best. Do you need more money every paycheck so you want to take your chances by paying fewer taxes throughout the year? Perhaps you are comfortable with paying more taxes with each paycheck because you want a large sum of money back every April.
Some count on that money to take a vacation every year. No one can really tell you what is best for your current situation, but there are many tax tools available to you to help you decide what is the best answer. You can make your taxes work for you. You can at least have a strong enough understanding of what is going to happen when you file your taxes so that you are not completely surprised by having to owe money. It really should not come as a surprise to you.
There are some ways to help yourself throughout the year and at tax time to make tax payment easier for you.
Tax Deductions
Now we are getting to the good stuff. These are common tax definitions that will help you while you are trying to reduce the amount of taxable income you have. There are some distinctions between tax deductions and tax credits that you want to know. It is important that you understand the details here because it makes a difference in how much money it can save you.
Tax deductions are ways that you can reduce your amount of taxable income and potentially change your tax bracket. When you move into a lower tax bracket it also lowers the percentage of taxes that you pay. The government offers you a standard deduction, or you can itemize your deductions. You can only do one or the other. You cannot do both. You have to decide which option is best for you.
Standard Deduction
The standard deduction allows every taxpayer to have some income that is not subject to federal income tax. The standard deduction can change each year. The 2022 standard deduction is $12,950 for single filers and those married filing separately, $25,900 for joint filers, and $19,400 for heads of household.
The standard deduction increases for those who are age 65 or older, or are blind. For those to receive the deduction for blindness, you can be totally or partially blind. IRS considers partial blindness to be someone that has 20/200 vision or a field of vision of no more than 20 degrees. You also need a signed and certified statement from your doctor stating that you have these vision problems.
Often time, people do not have enough deductions to be more than the amount of the standard deduction, so they take the standard deduction.
Tax Credits
Another one of the common tax definitions that you want to know is tax credit. A credit is different from a deduction in that they reduce how much you have to pay to IRS. Deductions reduce your taxable income, but credits reduce the amount you have to pay to the IRS.
For example, if you owe $50,000 in taxes to the IRS, but you have $20,000 in credits, you only owe $30,000. $50,000 - $20,000 (credit) = $30,000 owed. Do not expect that high of credit, I was just using it as an example.
Refundable and Nonrefundable Credits
When you want to significantly lower the amount of money you have to pay, tax credits are the best way to do that. There are various different tax credits for which you might qualify. There are nonrefundable tax credits. These credits mean that once they reduce your bill to zero, you do not get the rest of the money.
For example, you owe $50,000 (like above) and you have $60,000 in credits, which means your bill becomes $0 and there are $10,000 left in credits. They just go away. You do not get that money.
Now, there are also refundable credits. You get the entire amount of this credit so using the example above, if the $60,000 in credit was refundable credit, you would get a check for $10,000. There is also another category of credits, which is a partially refundable tax credit. This type of credit not only reduces the amount of money that you owe to the IRS, but it also reduces your taxable income.
Some of the credits for which you might qualify are earned income, low-income housing, child and dependent care credit, and making your house energy efficient. The IRS website has a long list of the tax credits for which you might qualify.
Withholding
Remember when you got your first job and you could not wait to get your first paycheck? You finally got it and you looked at how much money was in your check and you were quickly deflated. That is when you first found out about one of the most common tax definitions, withholding. Withholding is what you are responsible for paying in taxes with each paycheck.
They are called withholding because your employer withholds them from you when you are paid. There are quite a few line items on your paycheck for regular withholdings. These are items that you cannot control. The amount that is withheld is mandated by the government and it is based on how much you earn.
Taxes That Are Automatically Withheld
Some of the taxes that are automatically withheld from your paycheck are for Social Security, Medicare, and federal taxes. You may see line items for FICA and OASDI taxes. OASDI stands for Old Age, Survivors, and Disability Insurance and it is Social Security. You may also see a line item for Medicare taxes. Or you may see neither of those and you may see FICA, which stands for Federal Insurance Contributions Act. Just a reminder that these are taxes that are required by law for you to pay and you cannot change how much you pay.
The other line item you will see is your federal taxes, for which you are legally bound to pay. You may see it listed Federal Income Tax (FIT). Once again, you are not able to change the basic withholding for this type of tax. You can change your withholding amount so that slightly more or less is withheld, but in general, at least some type of taxes are withheld. If you do not pay enough taxes with each paycheck, you will have to pay more when you file your taxes.
Schedule C
When I mentioned business taxes earlier, I mentioned that there are separate forms that you have to file when it comes to businesses. One of those common tax definitions is the Schedule C. This document is your friend when you are filing business taxes. It is a worksheet that you use to determine how much profit you made in the tax year.
A Form for Business Taxes
This worksheet is where you itemize all the expenses you have for the business and are able to deduct them from your income for the same year. Your total income minus your expenses equals your profit, in this worksheet anyway. This is where you list your mileage and receipts from your business throughout the year. This is where you list everything you buy for your office, everything on which you spend money, and any trainings or seminars that you attend. You must provide receipts for them.
Tax Documents
There are some common tax definitions of documents of which you should be aware also. These are documents that you need to have when you file taxes, no matter if you do your own taxes, or have a professional handle them.
W2
This is a document that is a statement of how much money you earned during the tax year. This document also shows how much money was withheld from your earnings for taxes. Employers have until January 31 to send you this document. You may be able to receive it online, but some employers still mail them.
1099s
There are variations of this document. You need to keep every one that you receive and refer to it when you file taxes. A 1099 MISC is a form that shows all of your self-employment income. You only receive one of these if you earn more than $600 from one place. A 1099G is a form you get if you are receiving some type of governmental benefit, including unemployment. A 1099R is a form that you get when you have distributions from your IRA, retirement, pension, or annuity.
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Conclusion
There is a long list of common tax definitions of which you should be aware. I have not listed them all here because there are just too many. I have listed the major ones with which you should have some familiarity. When you have some understanding of these terms and documents, it makes things much easier for you when you file taxes. Most importantly, you need to accept that you must pay taxes. It is legally required of you. It does not benefit you to try to get around paying taxes.
If you try to hide money, the IRS always finds out, so just do not do it. The best way to protect yourself is to claim all income and use a reliable tax application to file your taxes. If you think you have too much and you cannot do your taxes on your own, you should hire a reputable and knowledgable accountant for your taxes. The best way to attack your taxes is with as much knowledge as you can find. When you know what is expected and all the deductions and credit available to you, filing taxes is not as scary as it once was.