If the very mention of a standard versus itemized deduction makes your eyes glaze over, listen up! There’s no need to study every word of the tax code. But being able to understand basic terms will make it easier to talk with your tax preparer and help ensure you’re filing properly. That can mean fewer possible penalties and, yes, more cash in your pocket.
Susan Clarke, CPA and founder of Clarke Public Accounting in Chicago, shares this crash course in talking the talk.
1. ADJUSTED GROSS INCOME
Your AGI is all of the income you received in that year—including wages, dividends, interest, and capital gains—minus any allowable deductions, such as alimony payments, moving costs, and some student loan interest. Your AGI affects many things, including how much you claim for itemized deductions and how much you’re allowed to contribute to individual retirement accounts (IRAs).
A person other than yourself or your spouse for whom you can claim a tax exemption. The IRS has detailed rules about who counts as a dependent, but in general think: a kid who lives with you more than half the year or a family member you support who makes less than $4000 a year.
These work like deductions, further reducing your AGI to arrive at your taxable income. You’re granted one exemption each for yourself, your spouse, and any dependents. For 2015, you can deduct $4000 for each exemption.
4. DEFINED CONTRIBUTION PLAN
This refers to retirement plans, like 401(k) and 403(b), in which the employee and/or employer contribute a certain amount but the value of the account will change over time. Not to be confused with a defined benefit plan (a.k.a. a traditional pension plan), where the retiree is promised a certain monthly benefit at retirement.
5. STANDARD DEDUCTION
The IRS sets the standard deduction for all taxpayers, based on filing type. For tax year 2015, the standard deduction is $6300 for single taxpayers and married taxpayers filing separately. It’s $12,600 for married couples filing jointly and $9250 for head of household. Taking this is a no-brainer—unless you crunch the numbers and you’ll save more by itemizing.
6. ITEMIZED DEDUCTION
If you think your itemized deductions are going to total more than your standard deduction amount, it may be worth itemizing instead. You can itemize both big-ticket items (mortgage interest, property and state income taxes, excess medical expenses) and smaller items (charitable contributions, job-search expenses). Itemized deductions are subtracted from your AGI to determine your taxable income.
7. TAX CREDIT
While deductions reduce your taxable income, credits are a dollar-for-dollar offset of the amount of taxes you owe. That means they’re much more effective at lowering your tax liability, and some credits are even refundable. The IRS reserves credits for things like childcare expenses, higher education costs, and earned income of low-income taxpayers.
These are the taxes taken out of your wages or other income before you receive your net paycheck. That tax money goes to the IRS, and the federal withholding offsets your tax liability, so you either owe taxes or receive a refund when you file your return.