Vocabulary Lessons

Tax credit: A credit that directly lowers your bill. This is like the dependent child credit. If your tax liability is 2000 and you have one child, it is reduced to $1,000, two children, $500, and so on.

Tax credits can be refundable and nonrefundable. The dependent child credit is nonrefundable, if your tax liability is $2000 and you have five children (a credit of $2500) your taxes are 0 not -$500.

The tax credit is refundable you take the full amount even if it pushes your tax liability into negative numbers. An example is the earned income credit, where the tax payer can receive a refund that is more than the amount withheld.

Tax deductions: Tax deductions reduce your taxable income. Mortgage interest and charitable contributions are the most commonly used. The money or a portion of the money spent on tax deductable items can be used to reduce your adjusted gross income, which can drop you into a lower tax bracket.

Tax incentives: Tax incentives are designed to promote and reward certain economic decisions. Here again we have the mortgage interest deduction, which is supposed to encourage home ownership.

Marginal tax rate A marginal tax rate is a system that taxes certain levels of your income differently as you move up into higher tax brackets. So if your adjusted gross income is 40K this year it is taxed at 15% and your tax bill is $6000. If you get a raise next year and your income goes up to 40K you will be taxed 15% on the first 30K and 25% on the 10K increased earnings, not on the full 50K. So your tax bill will be 40 x 15% = 6000 + 20 x 25% = 2500 = total tax of 8500.