Tax Terms

Tax deductions reduce an individual’s amount of taxable income. Types of deductions include “above-the-line deductions” and “below-the-line deductions.” Above-the-line deductions, also known as adjustments to income, are subtracted from a taxpayer’s gross income to arrive at their adjusted gross income (AGI). After arriving at their AGI, taxpayers can choose from two types of below-the-line deductions. These include standard and itemized deductions; individuals typically choose whichever type results in a lower amount of taxable income. Taxpayers are eligible for above-the-line deductions regardless of whether they choose to itemize or take the standard deduction.

Also known as adjustments to income, above-the-line deductions are expenses that can be deducted directly from a taxpayer’s gross income to arrive at his or her adjusted gross income (AGI). Taxpayers can claim these deductions regardless of whether they take the standard deduction or choose to itemize.

Above-the-line deductions include the following, subject to limitations:

• Deductible contributions to traditional IRAs (retirement savings accounts)

• SIMPLE and Keogh plans

• Contributions to HSAs (health savings accounts)

• Penalties paid on early savings withdrawals

• 50% of the self-employment tax paid by self-employed taxpayers

• Alimony payments for alimony agreements in place prior to December 31st, 2018

• Interest paid on higher education loans and certain qualifying college costs (subject to limitations)

• Jury duty pay forfeited to one’s employer

• Qualifying travel expenses for members of the Reserves and National Guard

The standard deduction is a type of below-the-line-deduction comprised of a specific dollar amount that can be subtracted from a taxpayer’s adjusted gross income (AGI) to reduce their amount of taxable income. An individual’s standard deduction amount is determined by their filing status. Individuals over 65 years of age and those who are legally blind are entitled to an additional standard deduction.

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Certain taxpayers are not eligible for the standard deduction. Ineligible taxpayers include:

• An individual who is married, filing separately whose spouse itemizes deductions

• Nonresident or dual status aliens

• Individuals filing a return for a period of less than twelve months due to a change in their yearly accounting period

• Estates, trusts, common trust funds, partnerships, S corporations, C corporations, or non-profits

Itemized deductions can be subtracted from one’s adjusted gross income (AGI) in lieu of the standard deduction. Taxpayers may opt to itemize their deductions if itemizing would result in a lower amount of taxable income than taking the standard deduction. Taxpayers who are ineligible for the standard deduction must itemize deductions. Expenses that qualify for itemized deductions include the following (subject to limitations):

• Out-of-pocket medical and dental expenses

• State and local taxes (SALT), subject to a $10,000 limit

• Home mortgage points

• Home mortgage interest expenses

• Charitable contributions

Governments offer tax credits as incentives to promote certain behaviors or support disadvantaged taxpayers. Whereas tax deductions reduce the amount of taxable income before arriving at one’s final tax liability, tax credits are subtracted directly from taxes owed to the government. This reduces an individual’s tax liability dollar for dollar, whereas deductions reduce one’s tax liability by only a percentage of each dollar.

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Tax credits can be either refundable or nonrefundable. If the total of an individual’s refundable tax credits is higher than their tax liability, the IRS passes along the difference in the form of a tax refund. Examples of refundable tax credits include the earned income tax credit and the first-time home-buyer credit. Nonrefundable credits, such as the credit for adoption expenses, cannot be used to create or increase a taxpayer’s refund. Some credits, such as the Child Tax Credit, are partially refundable.

Federal income and social security taxes are largely structured as “pay-as-you-go” tax systems. Employers withhold part of each employee’s paycheck throughout the year; this withheld amount goes toward the employee’s income taxes and social security taxes. A taxpayer’s withholding amount depends on their filing status, amount of income earned, and the number of withholding allowances claimed. Each withholding allowance reduces the taxpayer’s required withholding amount. Employees can also request that an additional amount be withheld from each paycheck. This is changing in 2019; due to the elimination of personal exemptions, the IRS is creating a new W-4.

The IRS encourages taxpayers to do a “Paycheck Checkup” early each year to determine their correct withholding amount. This is especially important for any taxpayer who received a tax bill with their most recent return; changing their withholding amount can help these taxpayers to avoid a tax bill with their next return. For taxpayers who didn’t owe taxes but received a smaller refund than expected with their most recent return, adjusting their withholding amount can help to ensure a larger refund the following tax season. The IRS also recommends checking one’s withholding amount in the case of a change in income or a major life event such as marriage or divorce, having a child, or buying a home.

You can perform your own “paycheck checkup” using the IRS's withholding online calculator.

Individuals who expect to make more than a certain amount of income for the year must make quarterly payments toward their annual tax bill if their income taxes are not covered by withholding.

The effective tax rate is the average federal tax rate paid by an individual or corporation. An individual taxpayer can arrive at their effective tax rate by dividing their total tax expense by their taxable income. Corporations can calculate their effective tax rate by dividing their total tax expense by their earnings before taxes. An individual’s or corporation’s effective tax rate is usually lower than their marginal tax rate.