Tax definitions

This page provides an overview of definitions of basic tax terms and concepts. The tax world can be very confusing, and it certainly helps to have at least the basic definitions on one page.

You are welcome to use the definitions below for reference purposes, but we advise you to always consult official IRS documentation and sources or your personal tax advisor before making decisions regarding your situation.

Adjusted Gross Income (AGI)

Adjusted gross income is the total income less some specific allowed deductions. Deductions may be for example paid alimony, some moving expenses, interest paid on student load, self-employed retirement program, and a few others.

Alternative Minimum Tax (AMT)

Because high-income taxpayers are in the highest tax brackets, they are often very well motivated to optimize their tax liability. They have the ability to shelter some of their income from tax through certain tax preference items or deductions. On the other hand, the government wants them to pay at least some taxes. If your income meets the limit for the alternative minimum tax, then your tax is not calculated using the regular tax rate schedule but using a separate alternative minimum tax rates and tables.

Capital Gain

Capital gain is the profit on the sale of a capital asset. Depending on your situation capital gains often receive more favorable tax treatment than regular income. Depending on your tax bracket and on how long you held an asset before selling it, you may be eligible for a reduced tax rate. See the Capital gains tax rates page.

Itemized Deductions

Itemized Deductions are other deductions that can be subtracted from your income to lower your tax base. These deductions include for example mortgage interest, property taxes, sales taxes, state income taxes, or charitable contributions.

Gross Salary

Gross salary is the amount that an employer pays out to employees. This figure is reported on the W2 which the employer sends in January to both IRS and the employee. If for example Joe Smith gets paid $20/hour as a website developer, then his annual gross salary would be $20/hour x 2,000 hours/year = $40,000/year.

Personal Exemption

Personal exemption relates to dependents. If you have dependents, you may deduct an amount from your gross income for each dependent you can claim. This exemption was $3,650 in the 2009 tax year.

Standard Deduction

Standard deduction is an easy way to take a deduction. If your itemized deductions are not more than the standard deduction, or if keeping track of itemized deductions and their accounting is not worth the time, then it is possible to take the standard deduction which is just a fixed plain amount that can be deducted from your income. Standard deduction was $5,700 for single and $11,400 for married filing jointly in the 2009 tax year (tax return filed in 2010).

Total Income

Total income is the sum of all taxable income, including the W-2 wages. Total income often includes also mutual fund capital gains, dividends, personal business income, stock capital gains, interest, and other. Most income is taxable. There are a few exemptions. For example non-taxable interest on government bonds, a portion of the Social Security (SS) income, some municipal bonds, and a few other types of income are excluded from taxation.

W-2 Wages

W-2 wages are the wages that appear on the employee’s W-2 form. This form is issued by employee’s employer and sent to the employee in January following the year in which the employee received the wage. The employer sends one copy of the employee and one copy to the Internal Revenue Service (IRS).

The employee has to report all pay reflected on W2 on his or her federal tax return. Unreported taxable income is a common red flag and cause IRS audit. The IRS has the ability to discover unreported taxable income when its computers match the taxable income employee reported on their tax returns with information gathered from employers. IRS has the ability to match employer's records against employee's tax return.

W-2 wages is the Gross Salary less any contributions to pre-tax plans.

The W-2 form also shows the amount withheld by the employer for federal income tax.

  Gross salary
- contributions to employer retirement plan
- contributions to employer health plan
- contributions to other tax deferred employer plans
= W-2 wages

Tax Bracket

Most countries employ so called graduated or progressive tax system. Graduated tax system is aiming higher tax rates at people with higher incomes. This means that the more you earn, the higher your tax rate will be. However, if you earn more, you will pay a higher tax rate on your "top" income. Tax brackets are the divisions at which tax rates change in a progressive tax system. Tax brackets are the cutoff values for taxable income. Income past a certain point is be taxed at a higher rate. This is explained at the Marginal and average tax rate page.