Understanding Tax Terminology

Article Highlights

• Filing status can be single, married filing jointly, married filing separately, head of household, or surviving spouse with dependent child.
• Adjusted gross income (AGI) is the sum of a taxpayer’s income minus specific subtractions called adjustments. Modified AGI is the regular AGI with certain adjustments and exclusions added back.
• Taxable income is AGI less deductions and exemption.
• Marginal tax rate is the tax percentage at which the top dollar of your income is taxed. Also referred to as your tax bracket.
• Alternative minimum tax (AMT) is a tax that you pay if it is higher than tax computed the regular way.  Certain deductions, credits and tax benefits are not allowed when computing the AMT.
• Credits reduce your tax dollar-for-dollar and some are refundable.
• Failing to prepay enough tax through withholding or estimated payments can result in an underpayment of estimated tax penalty.

No matter what the season or your unique circumstances, when it comes to your taxes, planning usually pays off in a lower tax bill. It can be difficult to understand tax strategies if you are not familiar with the terminologies used in taxation. The following provides you with the basic details associated with the most frequently encountered tax terms.

• Filing Status—Generally, if you are married at the end of the tax year, you have three possible filing status options: married filing jointly, married filing separately, or, if you qualify, head of household. If you were unmarried at the end of the year, you would file as single, unless you qualify for the more beneficial head-of-household status. A special status applies for some widows and widowers.

Head of household is the most complicated filing status to qualify for and is frequently overlooked as well as incorrectly claimed. Generally, the taxpayer must be unmarried AND:

• pay more than one half of the cost of maintaining his or her home, a household that was the principal place of abode for more than one half of the year of a qualifying child or an individual for whom the taxpayer may claim a dependency exemption, or

• pay more than half the cost of maintaining a separate household that was the main home for a dependent parent for the entire year.

A married taxpayer may be considered unmarried for the purpose of qualifying for head-of-household status if the spouses were separated for at least the last six months of the year, provided the taxpayer maintained a home for a dependent child for over half the year.

Surviving spouse (also referred to as qualifying widow or widower) is a rarely used status for a taxpayer whose spouse died in one of the prior two years and who has a dependent child at home. Joint rates are used, but no exemption is claimed for the deceased spouse. In the year the spouse passed away, the surviving spouse may file jointly with the deceased spouse if not remarried by the end of the year. In rare circumstances, for the year of a spouse’s death, the executor of the decedent’s estate may determine that it is better to use the married separate status on the decedent’s final return, which would then also require the surviving spouse to use the married separate status for that year.

• Adjusted Gross Income (AGI)—AGI is the acronym for adjusted gross income. AGI is generally the sum of a taxpayer’s income less specific subtractions called adjustments (but before the standard or itemized deductions and exemptions). The most common adjustments are job-related moving expenses, penalties paid for early withdrawal from a savings account, and deductions for contributing to an IRA or self-employment retirement plan. Many tax benefits and allowances, such as credits, certain adjustments, and some deductions are limited by a taxpayer’s AGI.
• Modified AGI (MAGI)—Modified AGI is AGI (described above) adjusted (generally up) by tax-exempt and tax-excludable income. MAGI is a significant term when income thresholds apply to limit various deductions, adjustments, and credits. The definition of MAGI will vary depending on the item that is being limited.
• Taxable Income—Taxable income is AGI less deductions (either standard or itemized) and exemptions. Your taxable income is what your regular tax is based upon using the tax rate schedule. The IRS publishes tax tables that are based on the tax rate schedules and that simplify tax calculation, but the tables can only be used to look up the tax on taxable income up to $99,999.
• Marginal Tax Rate (Tax Bracket)—Not all of your income is taxed at the same rate. The amount equal to the sum of your deductions and exemptions is not taxed at all. The next increment is taxed at 10%, then 15%, etc., until you reach the maximum tax rate. When you hear people discussing tax brackets, they are referring to the marginal tax rate. Knowing your marginal rate is important because any increase or decrease in your taxable income will affect your tax at the marginal rate. For example, suppose your marginal rate is 25% and you are able to reduce your income $1,000 by contributing to a deductible retirement plan. You would save $250 in federal tax ($1,000 x 25%). Your marginal tax bracket depends upon your filing status and taxable income. You can find your marginal tax rate using the table below.Keep in mind when using this table that the marginal rates are step functions and that the taxable incomes shown in the filing-status column are the top value for that marginal rate range.

2013 MARGINAL TAX RATES
TAXABLE INCOME BY FILING STATUS
Marginal Tax Rate	Single	Head of Household	Joint*	Married Filing Separately
10.0%	8,925	12,750	17,850	8,925
15.0%	36,250	48,600	72,500	36,250
25.0%	87,850	125,450	146,400	73,200
28.0%	183,250	203,150	223,050	111,525
33.0%	398,350	398,350	398,350	199,175
35.0%	400,000	425,000	450,000	225,000
39.6%	Over 400,000	Over 425,000	Over 450,000	Over 225,000

      * Also used by taxpayers filing as surviving spouse

• Taxpayer & Dependent Exemptions—You are allowed to claim a personal exemption for yourself, your spouse (if filing jointly), and each individual who qualifies as your dependent. The amount you are allowed to deduct is adjusted for inflation annually; the amount for 2013 is $3,900.
• Dependents—To qualify as a dependent, an individual must be the taxpayer’s qualified child or pass all five dependency qualifications: the (1) member of the household or relationship test, (2) gross income test, (3) joint return test, (4) citizenship or residency test, and (5) support test. The gross income test limits the amount a dependent can make if he or she is over 18 and does not qualify for an exception for certain full-time students. The support test generally requires that you pay over half of the dependent’s support, although there are special rules for divorced parents and situations where several individuals together provide over half of the support.
• Qualified Child—A qualified child is one who meets the following tests:

(1) has the same principal place of abode as the taxpayer for more than half of the tax year except for temporary absences

(2) is the taxpayer’s son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any such individual

(3) is younger than the taxpayer

(4) did not provide over half of his or her own support for the tax year

(5) is under age 19, or under age 24 in the case of a full-time student, or is permanently and totally disabled (at any age)

(6) was unmarried (or if married, either did not file a joint return or filed jointly only as a claim for refund)

• Deductions—Taxpayers can choose to itemize deductions or use the standard deductions. The standard deductions, which are adjusted for inflation annually, are illustrated below for 2013.

 

Filing Status	Standard Deduction
Single	$6,100
Head of Household	$8,950
Married Filing Jointly	$12,200
Married Filing Separately	$6,100

The standard deduction is increased by multiples of $1,500 for unmarried taxpayers who are over age 64 and/or blind. For married taxpayers, the additional amount is $1,200. The extra standard deduction amount is not allowed for elderly or blind dependents. Those with large deductible expenses can itemize their deductions in lieu of claiming the standard deduction.

Itemized deductions include:

(1) Medical expenses, limited to those that exceed 10% of your AGI for the year (Note: The limitation is 7.5% of AGI for seniors age 65 and older through 2016.)

(2) Taxes consisting primarily of real property taxes, state income (or sales) tax, and personal property taxes

(3) Interest on qualified home debt and investments; the latter is limited to net investment income (i.e., the deductible interest cannot exceed your investment income after deducting investment expenses)

(4) Charitable contributions, generally limited to 50% of your AGI, but in certain circumstances the limit can be as little as 20% or 30% of AGI

(5) Miscellaneous employee business expenses and investment expenses, but only to the extent that they exceed 2% of your AGI

(6) Casualty losses in excess of 10% of your AGI plus $100 per occurrence

(7) Gambling losses to the extent of gambling income, and certain other rarely encountered deductions

• Alternative Minimum Tax (AMT)—The Alternative Minimum Tax is another way of being taxed that taxpayers frequently overlook. An increasing number of taxpayers are being hit with AMT. The Alternative Minimum Tax (AMT) is a tax that was originally intended to ensure that wealthier taxpayers with large write-offs and tax-sheltered investments pay at least a minimum tax. However, even taxpayers whose only “tax shelter” is having a large number of dependents or paying high state income or property taxes may be affected by the AMT. Your tax must be computed by the regular method and also by the alternative method. The tax that is higher must be paid. The following are some of the more frequently encountered factors and differences that contribute to making the AMT greater than the regular tax.
  • Personal and dependent exemptions are not allowed for the AMT. Therefore, separated or divorced parents should be careful not to claim the exemption if they are subject to the AMT and instead allow the other parent to claim the exemption. This strategy can also be applied to taxpayers who are claiming an exemption under a multiple support agreement.
  • The standard deduction is not allowed for the AMT, and a person subject to the AMT cannot itemize for AMT purposes unless he or she also itemizes for regular tax purposes. Therefore, it is important to make every effort to itemize if subject to the AMT.
  • Itemized deductions:
    • Medical deductions are allowed in excess of 10% of AGI from 2013 through 2016. The amount of deductible medical expenses for regular tax and AMT will be different for seniors, who are allowed to claim medical deductions in excess of 7.5% of AGI for regular tax during this period. For other taxpayers, the medical deductions allowed for regular tax and AMT will be the same.
    • Taxes are not allowed at all for the AMT.
    • Interest in the form of home equity debt interest and interest on debt for non-conventional homes such as motor homes and boats are not allowed as AMT deductions.
    • Miscellaneous deductionssubject to the 2% of AGI reduction are not allowed against the AMT.
      • Nontaxable interest from private activity bonds is tax free for regular tax purposes, but some is taxable for the AMT.
      • Statutory stock options (incentive stock options) when exercised produce no income for regular tax purposes. However, the bargain element (difference between grant price and exercise price) is income for AMT purposes in the year the option is exercised.
      •  Depletion allowance in excess of a taxpayer’s basis in the property is not allowed for AMT purposes.

A certain amount of income is exempt from the AMT, but the AMT exemptions are phased out for higher-income taxpayers. The amounts shown are for 2013.

AMT EXEMPTIONS & PHASE OUT
Filing Status	Exemption Amount	Income Where Exemption Is Totally Phased Out
Married Filing Jointly	$80,800	$477,100
Married Filing Separate	$40,400	$238,550
Unmarried	$51,900	$323,000

 

AMT TAX RATES—2013
AMT Taxable Income	Tax Rate
0 – $179,500 (1)	26%
Over $179,500 (1)	28%

 ⁽¹⁾ $89,750 for married taxpayers filing separately
Your tax will be whichever is higher of the tax computed the regular way and the Alternative Minimum Tax. Anticipating when the AMT will affect you is difficult, because it is usually the result of a combination of circumstances. In addition to those items listed above, watch out for transactions involving limited partnerships, depreciation, and business tax credits only allowed against the regular tax. All of these can strongly impact your bottom-line tax and raise a question of possible AMT. Tax Tip: If you were subject to the AMT in the prior year, itemized your deductions on your federal return for the prior year, and had a state tax refund for that year, part or all of your state income tax refund from that year may not be eligible for inclusion in the regular tax computation. To the extent that you received no tax benefit from the state tax deduction because of the AMT, that portion of the refund is not eligible for inclusion in the subsequent year’s income.

• Tax Credits—Once your tax is computed, tax credits can reduce the tax further. Credits reduce your tax dollar for dollar and are divided into two categories: those that are nonrefundable and can only offset the tax, and those that are refundable. In addition, some credits are not deductible against the AMT, and some credits, when not fully used in a specific tax year, can carry over to succeeding years. Although most credits are a result of some action taken by the taxpayer, there are two commonly encountered credits that are based simply on the number of your dependents or your income. These and a third popular credit are outlined below.
  • Child Tax Credit—The child tax credit is $1,000 per child. If the credit is not entirely used to offset tax, the excess portion of the credit, up to the amount that the taxpayer’s earned income exceeds a threshold ($3,000 for 2011–2017) is refundable. Taxpayers with three or more qualifying dependent children may use an alternate method for figuring the refundable portion of their credit. The credit is allowed against both the regular tax and the AMT for each dependent under age 17. The credit begins to phase out at incomes (MAGI) of $110,000 for married joint filers, $75,000 for single taxpayers, and $55,000 for married individuals filing separate returns. The credit is reduced by $50 for each $1,000 (or fraction of $1,000) of modified AGI over the threshold.
  • Earned Income Credit—This is a refundable credit for a low-income taxpayer with income from working either as an employee or a self-employed individual. The credit is based on earned income, the taxpayer’s AGI, and the number of qualifying children. A taxpayer who has investment income such as interest and dividends in excess of $3,300 (for 2013) is ineligible for this credit. The credit was established as an incentive for individuals to obtain employment. It increases with the amount of earned income until the maximum credit is achieved and then begins to phase out at higher incomes. The table below illustrates the phase-out ranges for the various combinations of filing status and earned income and the maximum credit available.

2013 EIC PHASE-OUT RANGE
Number of Children	Joint Return	Others	Maximum Credit
None	$13,310 – $19,680	$7,970 – $14,340	$487
1	$22,870 – $43,210	$17,530 – $37,870	$3,250
2 3	$22,870 – $48,378 $22,870 – $51,567	$17,530 – $43,038 $17,530 – $46,227	$5,372 $6,044

 

• Residential Energy-Efficient Property Credit—This credit is generally for energy-producing systems that harness solar, wind, or geothermal energy, including solar-electric, solar water-heating, fuel-cell, small wind-energy, and geothermal heat-pump systems. These items qualify for a 30% credit with no annual credit limit. Unused residential energy-efficient property credit is generally carried over through 2016.
• Withholding and Estimated Taxes—Our “pay-as-you-go” tax system requires that you make payments of your tax liability evenly throughout the year. If you don’t, it’s possible that you could owe an underpayment penalty. Some taxpayers meet the “pay-as-you-go” requirements by making quarterly estimated payments. However, when your income is primarily from wages, you usually meet the requirements through wage withholding and rely on your employer’s payroll department to take out the right amount of tax, based on the withholding allowances shown on the Form W-4 that you filed with your employer. To avoid potential underpayment penalties, you are required to deposit by payroll withholding or estimated tax payments an amount equal to the lesser of:

1)     90% of the current year’s tax liability; or

2)     100% of the prior year’s tax liability or, if your AGI exceeds $150,000 ($75,000 for taxpayers filing as married separate), 110% of the prior year’s tax liability.

If you had a significant change in income during the year, we can assist you in projecting your tax liability to maximize the tax benefit and delay paying as much tax as possible before the filing due date.

Please call if this office can be of assistance with your tax planning needs.