Tax season is in full swing! Here are 5 tax terms you should know, regardless of your income or tax level.
# 1 - Gross income
Your gross income is the total amount of income, both earned through a job or side hustle and unearned through things like investment earnings and royalties, that you receive throughout the year.
If you only have one job and no other types of income, your gross income will be equal to the gross wages number on the W-2 you receive from your employer.
# 2 - Taxable Income
You taxable income is your gross income minus any adjustments, deductions, and exemptions that you’re eligible for.
Gross Income - Adjustments = Taxable Income
Most importantly, your taxable income is the only number that you’re actually taxed on. Most people think that your entire gross income is taxed, but that simply isn’t true. The tax bill you owe the IRS is actually calculated on this smaller number.
# 3 - Tax bracket
The amount of tax you ultimately owe depends on the tax bracket you fall into. Because we have a progressive tax system in our country, everyone’s first dollars of income are taxed at the same rate. But as you climb into higher income tiers, those additional dollars start getting taxed at higher rates.
This concept is explained thoroughly in my MONEY course. If you’re ready to finally understand how your tax bill is calculated (and, in so doing, discover potential ways to pay less in taxes), you can check out MONEY here.
# 4 - Total tax due & effective tax rate
Your total tax due is the amount of tax you owe the government based on your earnings, deductions, adjustments, and credits.
Your effective tax rate is your total tax due divided by your gross income.
Total Tax / Gross Income = Effective Tax Rate
This number is typically much lower than the rate associated with the tax bracket you’re in, and it’s a much more accurate representation of your real tax obligation.
# 5 - Tax refund
Your tax refund is simply the difference between the amount of tax you paid to the government over the year and your total tax due:
Tax you paid - Tax you owe = Tax refund
Most people owe less than they’ve paid, so they get a refund from the IRS. If you owe more than you’ve already paid in, then you’ll have to write a check to the IRS for the difference.
The important point to remember is that you don’t actually want to receive a large refund. This is a common misconception! Contrary to popular belief, your tax refund is not new or free money; it’s money you could have had in your pocket all year long to pay off debt, save, or invest.
If you receive a big refund, double check the W-4 you have on file with your company’s HR department to make sure it accurately reflects your current financial situation.