Important Tax Terms

In this topic, you'll learn:

• Key terms related to calculating taxable income.
• Key terms related to employment taxes.
• Key terms related to investment gains and losses.

---

Tax season can be a confusing and daunting time for many people. With so many rules, regulations, and important terms to understand, it's easy to feel overwhelmed. Let's explore and demystify a few key tax terms important to many taxpayers.

Adjusted Gross Income (AGI)

AGI is your total income for the tax year minus specific adjustments allowed by the IRS. It is not the same as your total income or your taxable income - it falls between the two.

To calculate AGI, start with your gross income, which may include wages, salaries, tips, interest, capital gains, rental income, and other sources. Then subtract certain adjustments - sometimes called "above-the-line" deductions - such as contributions to a traditional IRA or Health Savings Account (HSA), student loan interest, self-employment tax (the deductible portion), and contributions to a self-employed retirement plan.

The result is your AGI. From there, your taxable income is determined by subtracting either the standard deduction or your itemized deductions.

AGI matters because it affects more than just how much tax you owe. Many tax deductions and credits have eligibility thresholds based on AGI. For example, the Earned Income Tax Credit (EITC) and the Child Tax Credit phase out above certain AGI levels. AGI can also affect eligibility for education credits, the deductibility of medical expenses, and contribution limits for Roth IRAs.

Capital Gains and Losses

Capital gains are profits you realize when you sell an asset for more than you originally paid. Assets that can produce capital gains include stocks, bonds, mutual funds, real estate, and other property.

For example, if you buy 100 shares of a stock for $10 per share and then sell those shares for $15, you would realize a capital gain of $500 (100 shares x $5 per share). Similarly, if you buy a house for $200,000 and then sell it for $250,000, you would realize a capital gain of $50,000.

Capital gains can be either short-term or long-term. Short-term capital gains are realized on assets held for one year or less, while long-term capital gains are realized on assets held for more than one year. While short-term gains are taxed at your income rate, long-term capital gains are generally taxed at a lower rate - from 0% to 20%, depending on your income (high earners may be subject to an extra 3.8% tax as well).

It's important to note that capital gains are only realized when you sell an asset. If you hold onto an asset and its value increases, you will recognize a capital gain once you sell it. Conversely, if the value of an asset decreases, you would realize a capital loss if you sold the asset for less than you paid for it. Capital losses can be used to offset capital gains and reduce your overall tax liability.

Estimated Tax Payments

If you earn income that isn't subject to withholding - such as self-employment income, interest, dividends, or rental income - you may need to make estimated tax payments. These payments are made throughout the year to prepay your tax liability. 

Estimated tax payments allow you to meet the "pay-as-you-go" system of the U.S. tax system by making periodic payments throughout the year rather than waiting until the end of the year to pay your entire tax liability. Estimated tax payments are typically made four times a year, on April 15, June 15, September 15, and January 15 of the following year.

Filing Status

Your filing status is a category that determines how your tax return is filed and how much tax you owe. The filing status is based on your marital status, family situation, and other factors affecting your tax liability. 

There are five filing statuses:

• Single - This status applies to those who are unmarried or legally separated on the last day of the tax year. This status can also apply to divorced or widowed people who do not qualify for another filing status.

• Married Filing Jointly - This status applies to married couples filing joint tax returns. Both spouses report their income, deductions, and credits on the same return and are responsible for paying any tax owed.

• Married Filing Separately - This status applies to married couples who file separate tax returns. Each spouse reports their income, deductions, and credits on their return and is responsible for paying their own tax liability.

• Head of Household - This status applies to taxpayers who are unmarried or considered unmarried and who pay more than half of the costs of maintaining a home for a qualifying person, such as a child or other dependent.

• Qualifying Widow(er) with Dependent Child - This status applies to those who are widowed and have a dependent child. This status can be used up to two years after the spouse's death.

The filing status you select can significantly impact your tax liability, so it's essential to consider the options carefully.

Itemized Deductions

Itemized deductions are tax deductions that you can claim on your tax return to reduce your taxable income. These deductions allow you to deduct certain qualifying expenses from your taxable income, which can result in a lower tax liability. 

When filing taxes, you must choose either the standard deduction or itemize your deductions. The decision to claim itemized deductions or take the standard deduction depends on your financial situation and the amount of qualifying expenses you have incurred. Because of limitations on the types and amounts of expenses that can be itemized, only around 15% of taxpayers choose to itemize deductions.

Self-Employment Income

Suppose you work for yourself as a freelancer, independent contractor, sole proprietor, or small business owner. In that case, your income is considered self-employment income. Since this type of income is not subject to traditional employer withholding, you're responsible for paying your taxes, including self-employment tax, a Social Security and Medicare tax for self-employed individuals. 

To report self-employment income, you must file a tax return and report your income on Schedule C. The net income from Schedule C is then included on your tax return and is subject to income and self-employment taxes. Additionally, you must make quarterly estimated tax payments (see Estimated Tax Payments above).

Standard Deduction

The standard deduction is a fixed amount you can claim on your tax return without itemizing your deductions. It reduces the taxable income you must report to the government and is intended to simplify the tax filing process for taxpayers who do not have significant itemized deductions. The standard deduction amount varies depending on your filing status, with further adjustments for older adults and those who are legally blind. For the 2025 tax year, if you are single or married filing separately, your standard deduction is $16,100, while if you are married filing jointly your standard deduction is $32,200.

As a taxpayer, you can claim the standard deduction or itemize your deductions, but not both. The decision to take the standard deduction or itemize deductions will depend on your financial situation and the amount of qualifying expenses you have incurred. Around 90% of all taxpayers in recent years choose the standard deduction.

Tax Credits

Tax credits are a tax benefit that directly reduces the amount of tax you owe. Tax credits are more valuable than tax deductions because they reduce the tax owed dollar-for-dollar. 

Tax credits can be either refundable or non-refundable. Refundable credits, such as the Earned Income Tax Credit, can reduce your tax liability to zero and result in a refund if the credit exceeds the amount of tax owed. Non-refundable credits can only be used to reduce the amount of tax owed and cannot result in a refund.

Tax Deductions

Tax deductions are expenses or costs that you can subtract from your income to lower your taxable income and ultimately reduce the tax you owe. Examples of tax deductions include student loan interest, mortgage interest, contributions made to certain types of savings accounts, plus more.

You can take some deductions, such as those listed above when taking the standard deduction. Other deductions, such as state and local taxes, medical expenses, and others, require you to itemize your deductions and forgo the standard deduction.

Tax Bracket

A tax bracket is a range of income subject to a specific tax rate under the U.S. federal income tax system. The U.S. tax system is progressive, meaning your tax rate increases as you earn more. 

There are seven tax brackets ranging from 10% to 37% of taxable income. The tax brackets are typically adjusted annually to account for inflation and vary depending on your filing status. When your income falls into a specific tax bracket, you pay the corresponding tax rate on the portion of your income within that bracket.

It's important to note that the tax bracket only applies to the portion of income that falls within that bracket, not the entire income. Even high-income taxpayers may pay a lower overall tax rate than their top tax bracket if most of their income falls into lower tax brackets.

Withholding

Tax withholding refers to an employer deducting a portion of your wages or salary to cover your expected income tax liability. Employers are required by law to withhold federal and state income taxes from your paychecks and to remit those taxes to the government on your behalf. When you start a new job, you must fill out a W-4 form, which helps the employer determine how much tax to withhold from your pay.

The tax withheld from your pay is based on several factors, including income, filing status, and the number of allowances you claim. If you have too much tax withheld from your pay, you will generally be owed a refund when you file your tax return - though in some cases, refunds may be applied to outstanding debts or other obligations. If you have too little tax withheld, you may owe additional taxes when you file your tax return and may be subject to penalties and interest for underpaying taxes. 

It's important to review your withholding periodically to ensure that you have the correct amount of tax withheld from your pay based on your current tax situation. You can use the IRS Withholding Calculator to estimate your tax liability.