Saving on your taxes over time can greatly increase your net worth. Paying for college incorrectly can set you back. By arming yourself with the knowledge needed to understand taxes related to higher education, you can save on taxes while paying for college. Here are 17 tax terms to know with a college-bound child and their definitions.
1. Tax Deduction
A tax deduction reduces the amount of income subject to tax. This will ultimately lower the overall tax you owe. Tax deductions can come in the form of federal or state taxes.
2. Tax Credit
A dollar-for-dollar reduction in the amount of tax owed. Tax credits directly reduce the tax liability and can be more valuable than deductions. Common examples include the Child Tax Credit & Child and Dependent Care Credit.
3. Adjusted Gross Income (AGI)
Adjusted Gross Income (AGI) is defined as gross income minus adjustments to income. Gross income includes your wages, dividends, capital gains, business income, retirement distributions as well as other income. Adjustments to Income include such items as Educator expenses, Student loan interest, Alimony payments or contributions to a retirement account. AGI is used to determine eligibility for certain tax benefits, such as tax credits & deductions. Be sure to check out my post on cutting Adjusted Gross Income.
4. Filing Status
The classification that determines the tax rates and standard deduction available to a taxpayer. Common filing statuses include Single, Married Filing Jointly, Married Filing Separately, Head of Household, and Qualifying Widow(er) with Dependent Child. In addition to your tax rate and standard deduction, how you file could determine retirement account contribution eligibility, and tax credit and deduction eligibility.
5. Taxable Income
The portion of income subject to tax after accounting for deductions and other adjustments.
6. Federal Income Tax
A tax levied by the U.S. federal government on an individual or entity’s taxable income.
7. State Income Tax
A tax imposed by individual states on an individual or entity’s taxable income. Some states do not levy an income tax, while others levy income taxes at different rates.
8. Tax Bracket
A range of income to which a specific tax rate is applied. The federal income tax system is progressive, meaning that higher income is subject to higher tax rates. Check here for 2023 income tax rates.
9. Withholding
The amount of tax deducted from an individual’s paycheck by their employer to cover their estimated tax liability. Withholding helps taxpayers meet their tax obligations throughout the year.
10. Estimated Tax
Quarterly payments made by individuals who expect to owe a significant amount of tax at the end of the year. Estimated tax payments help taxpayers avoid penalties for underpayment.
11. Taxable Interest
Interest earned on investments or savings accounts that is subject to income tax. Examples include interest earned on bank accounts, bonds, non-qualified brokerage accounts and certificates of deposit (CDs). This is unlike accounts that are tax-deferred.
12. Capital Gains
Profits realized from the sale of an asset, such as stocks, real estate, or mutual funds. Check here for 2023 capital gains rates.
13. Itemized Deductions
Specific expenses that taxpayers can deduct from their taxable income instead of taking the standard deduction. Common itemized deductions include medical expenses, state and local taxes, mortgage interest, and charitable contributions. Due to legislation passed back in 2018, it’s estimated only 10% of taxpayers itemize their deductions.
14. Standard Deduction
A predetermined deduction amount that taxpayers can subtract from their income based on their filing status. It is an alternative to itemizing deductions.
15. Taxable Benefits
Certain non-cash benefits provided by an employer, such as health insurance, company cars, or housing, that are subject to income tax.
16. Dependent
An individual, typically a child or relative, who relies on another person for financial support. Claiming a dependent can provide tax benefits, including exemptions and credits. NOTE: This is different than a “dependent student,” which is a financial aid term used when completing the FAFSA.
17. Education Tax Benefits
Tax incentives and credits available to help offset the costs of education, including the American Opportunity Tax Credit (AOTC), Lifetime Learning Credit (LLC), and Student Loan Interest Deduction.
