Updated: Mar 7
Each year, millions of taxpayers file Form 1040 to let the IRS know how much they made throughout the year. Taxpayers sign that tax return and have no idea what the tax return is saying. Is it you? Are you one of those taxpayers?
Every taxpayer has the right to understand what is on their tax return. Today we're going to go over 15 terms every taxpayer should know before they sign a tax return. It doesn't matter if this is your first year filing or if this is the 40th return you filed. These 15 terms are going to be relevant to you, even if you don't have a business or anything special on your tax return. So let's get right to it.
#1 - Form 1040
Form 1040 is also known as the tax return. I'm starting right here because taxpayers use tax refund and tax return as synonyms. They are quite different. Form 1040 is the form that individuals use to report their income throughout the years to the IRS.
As of right now, it is two pages and then there are more schedules to back up what's shown on Form 1040. But Form 1040 gives a summary of all your financial activity for the year to report to the IRS.
#2 - Gross Income
Gross income is your income before any deductions. Examples of gross income are wages, business income, dividend income, and interest income. I want to note this here because often I see people get confused by this, too. Gross income is not what gets taxed.
Gross income is the starting point.
#3 - Tax Deduction
Tax deductions are often confused with tax credits. A tax deduction lowers the amount of your taxable income.
For example, let's say that your gross income is $100,000. You are married and filing with your spouse. The 2021 standard deduction for married couples filing together is $25,100. After applying this deduction you only $74,900 gets taxed not $100,000.
# 4 - Adjusted Gross Income
Adjusted gross income is also known as AGI. Your adjusted gross income is the income after all adjustments. Adjustments are like deductions, they lower your taxable income. It's important to know your AGI or adjusted gross income is what lenders look at to see what your ability to pay is.
For example, if you go to apply for a mortgage, yes, the mortgage company and lenders want to see your tax return. But the main number they're looking at is your AGI, your adjusted gross income. Student loan lenders also look at your AGI. It tells them how much you can pay if you are on an income-driven repayment plan.
#5 - Standard Deduction
The standard deduction is a fixed amount that the IRS allows taxpayers to deduct. Each year the standard deduction goes up a little bit for inflation. Spoiler alert: it doesn't quite keep up with the rate of inflation. It's a good thought and theory.
I mentioned before, the 2021 standard deduction for MFJ (married filing jointly) is going to be $25,100. The standard deduction is different for each filing status. So it's different for single, head of household, or qualifying widower. It's also different for married couples filing separately.
#6 - Itemized Tax Deduction
When you hear a tax professional refer to itemized deductions. This is for taxpayers who usually own a home. They often give to charities throughout the year, and they pay a lot in state, local, and real estate taxes.
Now, the difference between the standard deduction and itemized deduction. Remember, the standard deduction is going to be a fixed amount that the IRS allows. Itemized deductions go over the amount of the standard deduction. If that's the case for you should itemize your tax deductions.
An example of an itemized deduction is medical expenses. The IRS limits this deduction based on your AGI. The IRS also limits state, local, property, and real estate taxes to $10,000. Charitable contributions can be 50% of your AGI. (100% for 2020 and 2021)
#7 - Taxable Income
Taxable income is the amount that is actually taxed by the IRS.
Your gross income is the foundation to figure your taxable income. Your gross income with all adjustments gives us your AGI. Once we have your AGI we apply the standard deduction or itemized ductions to get your taxable income.
Your taxable income gives us your tax liability by applying the right tax bracket.
# 8 - Tax Liability
Your tax liability is the amount of money you owe the IRS based on your income. This, too, is a term that taxpayers confuse. They believe that if they get a refund, that means they did not have a tax liability.
If you make more money than the amount of the standard deduction then you have a tax liability.
So let's say in 2020, the standard deduction for a single taxpayer was $12,400. If said taxpayer made more than $12,400, they had a tax liability.
Now, having a tax liability doesn't mean that you're going to owe the IRS at the end of the year. We have a progressive, pay-as-you-go tax system. If you work for somebody and receive a W2 they are withholding tax payments on your behalf. They are also paying them to the IRS. This is what keeps you from actually owing at the end of the year.
Your tax liability is your monetary obligation to pay based on your taxable income.
#9 - Tax Credit
A tax credit reduces your tax liability dollar for dollar. Tax credits are often confused with tax deductions. They are often used as synonyms. Nine times out of ten, a tax deduction is actually going to be better than a tax deduction. So the IRS looks at payments as a credit towards your tax liability. Also, we have things like the child tax credit and additional child tax credit(ACTC).
If you had a tax liability of $2,000 in 2020 and you have a child you could use the child tax credit. The child tax credit was $2,000. The $2,000 child tax credit dollar for dollar canceled the liability. It also allowed you to get back whatever you had paid in throughout the year.
Now there are two types of tax credits. There are non-refundable tax credits and refundable tax credits.
#10 Non-refundable tax credit
A nonrefundable tax credit can only cancel out the amount of the tax liability that you have. Let's use the example above. But this time, instead of a $2,000 tax liability, you have a $1,500 tax liability.
The child tax credit because it's non-refundable can only be $1,500. It can only zero out your liability completely.
#11 - Refundable Tax Credit
A refundable tax credit can equal dollars in your pocket. The amount of the credit left after reducing your tax liability goes toward your tax refund.
Let's use the same example as above. If you have a $1,500 tax liability and a $2,000 child tax credit. That tax credit is can only be $1,500 because it is non-refundable, reducing it by $$500. The beauty of the child tax credit in 2020 is that if you can't use the full amount, it turns into the ACTC. (This is different for the tax year 2021).
The IRS allows you to receive refundable tax credits in the form of a refund dollar for dollar. So we have a $1,500 tax liability. We have the $2,000 child tax credit reduced to $1,500. Now the remaining $500 is going to be refundable.
#12 - Tax Payments
Tax payments are what you pay during the year toward your tax liability. For myself and other employed individuals, we make quarterly estimated tax payments. People that work a W2 job make tax payments through their employer.
These payments go toward your liability. If your credits cancel out your liability then you get a tax refund of the payments made. If you are short on your payments, then you have an amount due.
But first, if you look at the 1040 page two, it looks to see whether you have a tax refund. First, a tax refund is not a tax return. You have to file a tax return, but a tax refund is if you have an overpayment of your taxes.
#13 - Tax Refund
A tax refund is an overpayment of tax payments given back to you.
Now, remember, because you get a tax refund does not mean you didn't have a tax liability. You having a tax liability does not mean that you will not get a tax refund.
For example: If you have enough non-refundable tax credits to cancel out your liability. You will get any remaining credits back in the form of a refund. If there are no credits remaining you will receive any payments made back. Unless you have a back tax obligation or another government garnishment.
#14 - Amount You Owe
Everybody's situation is not the same. Sometimes you didn't have enough money withheld. You messed up on your quarterly estimated payments or didn't even make any. This ends up being the amount that you owe. Pretty straightforward.
If you have an amount that you owe, this is always due on the tax deadline. April 15th is tax day but in 2021 and 2020, we saw our tax seasons extended so I won't put a date on it.
Let's use 2020 as an example. The tax deadline was May 17th. The amount you owe is due May 17, whether you actually file your return on May 17th or not. This is very critical information. As soon as May 17th went by, if you had not paid the amount that you owe, penalties and interest would start accruing. This applies even if you filed an extension. A tax return extension is an extension to file, not an extension to pay.
#15 - PTIN
PTIN is an acronym and it stands for Preparer Tax Identification Number. Everybody should know what a PTIN is. If you are paying a preparer to do your return, they should not be using TurboTax HR Block online.
They should be using professional tax software. At the bottom of your return under the paid preparer information, the PTIN should be there. This preparer tax Identification number is a must for paid preparers. The IRS issues this number, saying the preparer has the OK to be able to prepare tax returns. If your preparer is putting self-prepared on the bottom of your return you should run. That means they are not taking any credit for doing this return before the IRS.
The IRS requires all preparers to put their PTIN at the bottom of a tax return they received payment for. If your preparer is not doing this they are not authorized by the IRS to receive payment for doing your tax return.
All taxpayers have the right to know these 15 things about their tax returns. You deserve to know the difference between a credit and a deduction. You also deserve to know how the IRS figures your taxable income and liability.
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Timalyn S. Bowens EA is America's Favorite EA and Louisville's Tax Expert that will work hard to find a legal solution that is customized for you! As an Enrolled Agent licensed through the Internal Revenue Service Timalyn is able to fight the IRS for taxpayers in all 50 states.
When you are facing questions regarding your personal or business taxes, working with a professional makes all the difference. At Bowens Tax Solutions, we serve our Louisville-area neighbors by providing the tax services and knowledge needed to succeed. We are here to assist you with your tax issues and preventative care. Visit our website at www.bowenstaxsolutions.com for more information.