When discussing taxes, reading tax-related articles or instructions, one needs to understand the basic terminology and acronyms used by tax professionals and authors to grasp what they are saying. It can be difficult to understand tax strategies if you are not familiar with the basic terminologies used in taxation. The following provides you with the basic details associated with the most frequently encountered tax terms.
The standard deductions, tax rates, amounts that can be contributed to retirement plans, virtually all amounts claimed as deductions, and credits are annually adjusted for cost-of-living changes from the prior year or another base year as required by the tax code. Thus, when determining an amount, care should be taken to determine the year-specific amount. The numbers used in this article are for the year 2021.
Generally, suppose you are married at the end of the tax year. In that case, 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 are eligible for the more beneficial head of household status. A special status applies to 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 certain dependent relatives, 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 to qualify for head of the household status if the spouses were separated for at least the last six months of the year, provided the taxpayer wanting to be eligible for the head of household status 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. The main benefit of this status is that the widow(er) can use the more favorable married joint tax rates rather than the head of household or single rates. 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.
Suppose a taxpayer is married to a non-resident alien. In that case, the taxpayer has two options: file as married separate, reporting only their income, deductions, and credits, or elect to file a joint return with the spouse, including the worldwide income of both of them on a joint return.
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 certain below-the-line deductions and the standard or itemized deductions). The most common adjustments are penalties paid for early withdrawal from a savings account and deductions for contributing to a traditional IRA or self-employment retirement plan. Many tax benefits and allowances, such as credits, specific adjustments, and some deductions, are limited by the amount of 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 is AGI less deductions (either standard or itemized). Your taxable income is what your regular tax is based upon using a tax rate schedule specific to your filing status. The IRS publishes tax tables based on the tax rate schedules and simplifies the tax calculation, but the tables can only be used to look up the tax on taxable income up to $99,999. The tables for 2021 have not been released yet, but those for 2020 can be found in the 1040 instructions beginning on page 66.
Marginal Tax Rate (Tax Bracket)
Not all of your income is taxed at the same rate. The amount equal to your standard or itemized deductions is not taxed at all. The next increment is taxed at 10%, then 12%, 22%, etc., until you reach the maximum tax rate, which is currently 37%. 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 24%, and you can reduce your income by $1,000 by contributing to a deductible retirement plan. You would save $240 in federal tax ($1,000 x 24%). Your marginal tax bracket depends upon your filing status and taxable income. You can find your marginal tax rate for 2021 by using the table below.
Taxpayer & Dependent Exemptions
In the past, taxpayers could qualify for an exemption amount for the filer, spouse filing jointly, and each dependent, which was also subtracted from AGI to determine taxable income. However, beginning in 2018 and through 2025, the deduction for the exemption amounts has been suspended and replaced with a higher standard deduction and child tax credit.
A qualified child meets the following tests:
Has the same principal place of abode as the taxpayer for more than half of the tax year except for temporary absences;
Is the taxpayer’s son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any such individual;
Is younger than the taxpayer;
Did not provide over half of his or her support for the tax year;
Is under age 19, or age 24 in the case of a full-time student, or is permanently and disabled (at any age); and
Was unmarried (or if married, either did not file a joint return or filed jointly only as a claim for refund).
Even though there’s currently no deduction for dependent exemptions, there are still some significant tax benefits for taxpayers who can claim a dependent. To qualify as a dependent, an individual must be the taxpayer’s qualified child or pass all five of the following 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 an individual can make and still qualify as a dependent 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. However, there are special rules for divorced parents and situations where several individuals together provide over half of the support.