10 Tax Terms You Need to Know

We help translate your tax return so you can save money.

By Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance

February 2009

Does preparing your income-tax return remind you of taking a final exam in a foreign language that you don't understand? We can help. Think of Kiplinger as your Berlitz guide to taxes. We've translated key words so that you can understand not only what they mean but also how they can help you lower your tax bill.

Start with adjusted gross income. AGI includes your total income from all taxable sources (such as wages, interest, dividends, and self-employment and rental income) minus certain adjustments (see below). AGI is the key to determining your eligibility for certain tax benefits -- or, if it is too high, your exclusion from them.

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Some of those adjustments to income, also known as above-the-line deductions, include deductible contributions to IRAs and Health Savings Accounts, student loan interest, travel expenses for military reservists, job-related moving expenses, and out-of-pocket expenses for teachers who purchase classroom supplies. You can claim these tax breaks whether or not you itemize your deductions (see below) and use them to reduce your AGI.

You can also deduct a personal exemption, worth $3,500 apiece in 2008, for yourself, your spouse and each of your dependents. So a family of four could deduct $14,000 in personal exemptions from their taxable income on their 2008 tax return.. (The value of exemptions is partially phased out at higher income levels.)

Deductions are certain expenses you are allowed to subtract from your taxable income before figuring your taxes. You can choose either the standard deduction, which is $5,450 for individuals, $8,000 for those filing as head of household and $10,900 for married couples in 2008.

Taxpayers 65 and older can claim an extra standard deduction of $1,050 per person. And, there are two additional standards deductions new for 2008. Homeowners who do not itemize can claim an extra standard deduction for real estate taxes they paid, up to $500 for individuals or $1,000 for married couples. There is also an additional standard deduction for casualty losses in federally declared disaster areas.

Instead of taking these standard deductions, you can add up all of your itemized deductions if that would result in a bigger amount. Itemized deductions include write-offs for expenses such as real estate taxes, state income taxes, mortgage interest and charitable contributions.

Your taxable income is the amount on which your federal income tax is actually based. You then apply your tax rate, which ranges from 10% to 35%, to your taxable income to determine your tax.

While a deduction reduces the amount of income subject to tax, a tax credit is even more valuable because it reduces your actual tax bill dollar for dollar. Say that after subtracting all of your exemptions, adjustments to income and deductions to get your taxable income and then applying your tax rate to that, your tax is $12,000. Depending on your income, if you have two children younger than 17, you may qualify for $2,000 in child tax credits and reduce your tax bill to $10,000. Other tax credits for 2008 offset the cost of day care for young children, college costs, and retirement savings for low-income workers. While most tax credits cannot reduce your tax liability below zero, some are refundable, meaning you may get money back.

Usually there is a phaseout range in which you qualify for a partial tax break at certain income levels before the break disappears altogether. For example, if you are single and buy your first home in 2009, you can claim a tax credit of up to $8,000 if your income is $75,000 or less. The credit phases out as your income increases above $75,000 and disappears altogether at $95,000. So if your income was $85,000, you could claim a credit of $4,000. (And you can even claim your credit on your 2008 tax return.)

Some taxpayers have to figure their taxes twice -- once under the regular tax rules and once under the alternative minimum tax -- and pay whichever amount is higher. The AMT was created 40 years ago to ensure that wealthy taxpayers couldn't use loopholes to wipe out their entire tax bill. But because it was never indexed to inflation, the AMT increasingly affects middle-income taxpayers. The stealth tax disallows many of the usual tax breaks --- such as deductions for state and local taxes, and personal exemptions for you, your spouse and dependents -- so you end up paying taxes on a larger share of your income.

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