Income Tax Terms are Often Misunderstood
Income taxes and the underlying tax code in the United States are certainly complicated, and many taxpayers really don’t know much about the law or the process of collecting and paying income taxes. For the most part, they don’t have to; their tax preparation is handled by software or perhaps a professional tax preparer, and all the taxpayers have to do is provide the appropriate information in order to file their annual tax return. For most people, the only thing that really matters is the amount of the income tax refund that’s coming back to them.
That’s fine, as far as it goes, but there are some things that do require attention from taxpayers from time to time, and due to the complexities of the tax code, a lot of people misunderstand relatively common terminology related to income taxes. Most of the time, this doesn’t matter, but as with most subjects, the better informed you are, the less likely you are to get into trouble. When it comes to income taxes, you’ll find that the better informed you are, the greater the likelihood that you’ll be able to find a way to save money and that means a larger refund. That’s always a good thing.
Below are a few of the most commonly misunderstood income tax terms.Marginal tax rate – This might be the single most misunderstood income tax term of all. The marginal tax rate is often understood to refer to an overall rate of taxation that applies to all of a taxpayer’s income. In fact, that couldn’t be farther from the truth. The marginal tax rate is actually the rate that applies to the last dollar you earn. US tax rates are divided into several “brackets” and once your income reaches a level to move you to a higher bracket, only income earned above that figure is taxed at that rate. We’ve heard complaints from people over the years about how receiving a raise caused their paychecks to grow smaller because “I’m in a higher tax bracket now.” It doesn’t work that way; only income earned above the threshold for a particular tax bracket is taxed at that rate. In the mid-1950s, the top marginal tax rate in the US was 91%, but that only applied to income above some $3 million per year. Even the very wealthy paid lower rates on their first $2,999,999 in income.
Marriage penalty – If you hear the term “marriage penalty”, you might think that the IRS is intentionally punishing married people, which might sound odd, particularly since politicians are often going on about how important it is to them to see people get married. What’s the “marriage penalty” about? In actuality, there is no such thing in tax law as a “marriage penalty”; it’s just a quirk of tax rates that can occasionally come into play when two married people earn an amount of money that might cause them to have to pay more in income taxes than they otherwise might if they were single and filing separately. The nature of the tax code makes it difficult to eliminate this, and for the time being, it’s simply an inconvenience that married people have to endure. On the other hand, married couples enjoy more than 1000 Federal benefits for being married, so perhaps, in the long run, it’s all a wash.
Tax Credits and Tax Deductions – These terms are often used interchangeably, when they actually refer to different things. The IRS permits certain things to be deducted from gross income, such as mortgage interest or medical expenses or business expenses. These things are subtracted from the gross income, and income taxes are then applied to what remains, known as the net income. Income tax deductions reduce the income which is to be taxed. A tax credit on the other hand, is a figure that may actually be subtracted from the amount of tax owed. If you buy $5000 in office equipment and are eligible to use that expense as a deduction, you may reduce your income by $5000 before being taxed on what remains. On the other hand, if you install solar panels and are entitled to a $5000 credit for that installation, you may deduct $5000 from the amount of tax that you owe. Tax deductions are nice; tax credits are great.
Taxable income – This refers to whatever income you may have that is deemed by the IRS to be subject to income taxes. It generally applies to most wages and interest or investment income, after eligible tax deductions have been taken. Some income, such as certain municipal bond interest, has been deemed nontaxable and that income is free of taxation. There can be a huge difference in one’s total income and one’s taxable income, depending on a variety of factors. In the end, the taxable income is the amount with which the IRS is concerned; it’s the amount on which you owe money.
The tax code is quite complex, and the amount of money you pay in taxes is determined largely by the number of deductions you can take against your gross income. The more deductions you can take, the more likely you are to pay less in taxes. The problem is that most taxpayers have no idea how many deductions they can take, nor are they aware of all of the ways in which they can legally deduct expenses from their income. This isn’t about ignorance; it’s about a tax code that is tens of thousands of pages long.
Most taxpayers would gladly embrace the opportunity to save on their taxes if they knew there was an easy way to learn about the deductions to which they are entitled to take. After all, who wouldn’t willingly pay less in taxes if they only knew how to do it? Most taxpayers don’t have to time to read the tax code and likely wouldn’t understand it even if the did have the time. That’s why it’s better to take advantage of the knowledge of those who work in the industry, who can share that information in easy, simple to understand English.
Taxes are unnecessarily complicated, but that doesn’t mean you have to keep paying more in taxes than you have to.