Understanding your 2021 taxes: five key terms to know

It’s that time of year again: tax time. If you typically get a refund, this can be a great time, and you might look forward to it! For others, tax season may result in anxiety, frustration and a big bill; add the confusion many of us feel over common tax terms, and it can all become one big headache! Learning these key terms before you prepare your 2021 taxes can ease that headache a bit.

1) The New W-4

In 2020, the Internal Revenue Service (IRS) made significant changes to the tax withholding process, starting with the W-4 form. Before 2020, your allowances were based on how many “allowances” you claimed on your W-4. These are no longer used. According to the IRS website, “This change is meant to increase transparency, simplicity, and accuracy of the form. In the past, the value of a withholding allowance was tied to the amount of personal exemption. Due to changes in the law, currently you cannot claim personal exemptions or dependency exemptions.” You might be thinking, “What does that even mean?” Let me try to explain.

The allowances on the old W-4 helped determine how much was taken out of your check each payday. The fewer allowances you claimed, the more money was taken out for taxes, and vice versa. Many purposely kept their allowances low to get a bigger tax refund at tax time — talk about enforced saving! Others would intentionally raise their allowances to increase their take-home pay. While there was nothing illegal about that, it resulted in a large tax bill the following year, resulting in debt accrual for many people. Now, your withholding is based on the number of jobs and amount of income in your household, as well as your tax filing status (single, married filing jointly, married filing separately or head of household).

The best thing to do is to complete a “paycheck checkup” with the withholding calculator at the IRS website. You will need your (and your spouse’s, if applicable) most recent pay stubs from each job and about an hour to answer the questions. This will help you decide if you need to raise or lower your withholding by filling out a new W-4. (Note: The IRS says this calculator is currently down for maintenance until at least early February 2022.)

Have more questions? Visit this FAQ page at the IRS.

2) Tax Credits

Tax credits reduce your tax bill by giving you dollar-for-dollar credit towards what you owe; e.g., if you are eligible for a $500 tax credit, your tax bill will be reduced by $500. They can be refundable or non-refundable. Non-refundable tax credits are the most common and can be used to reduce your tax to zero, but not below. Some examples of non-refundable tax credits include the Adoption Tax Credit, the Child Tax Credit and the Mortgage Interest Tax Credit.

Refundable tax credits allow you to reduce your tax liability and will provide a refund. The most well-known example is the Earned Income Tax Credit, which is a poverty-fighting measure that essentially provides a subsidy for low-income working families. (Learn more about eligibility here.)

There are also partially-refundable tax credits. As the name implies, these credits will reduce your tax bill, but if your bill goes below zero, only a portion of the credit may be refunded. A good example is the American Opportunity Tax Credit, which is a credit for tuition paid at higher institutions of learning. (Learn more about education-related tax benefits here.)

3) Tax Deductions

Deductions reduce the amount of income on which you must pay tax. Unlike a tax credit, they are not dollar-for-dollar. Instead, they reduce your taxable income at a level equal to the percentage of your marginal tax bracket (see below). For example, if you’re in the 25% tax bracket, a $500 tax deduction will save you $125 in taxes (because 0.25 × $500 = $125).

Some deductions reduce your taxable income immediately, like payroll deductions. These may include pretax medical insurance premiums, dental insurance premiums, retirement account contributions, flex spending accounts and health savings accounts. Your employer might offer even more pretax deductions than these.

Other deductions reduce your income at a later date, like when you are figuring out how much tax you owe. The standard deduction reduces your taxable income by $12,500 for single people and $25,100 for married couples for the 2021 tax year. You might be able to further reduce your taxable income through itemized deductions for things like student loan interest payments, health care expenses, state sales or income tax reductions, Military Reserve travel expenses, job hunting expenses and even moving costs for your first job out of college!  Make sure to explore which deductions you qualify for when preparing your taxes (or having someone else do it for you), or review the page on the IRS website that further explains credits and deductions.  

A note about credits and deductions: the rules and eligibility can change from year to year, so eligibility for a credit or deduction one year doesn’t guarantee eligibility the next.

4) Filing Status

There are four different filing statuses:  single, married filing jointly, married filing separately, and head of household. Your filing status matters in many ways. It will determine how much you can claim for a standard deduction, which credits and deductions you may be eligible for, and what your tax bracket is. If you are married, filing separately might significantly increase your tax liability, so make sure you research the impact this could have on your situation or consult a tax professional.

5) Tax Brackets

You may have heard of terms like marginal tax rate and effective tax rate, but what do they mean? Tax brackets determine what your tax rate will be, and there are different tax brackets depending on how you file your taxes. Look up yours here. Brackets are, in my opinion, where most misunderstandings of tax rates occur. Let me break it down for you.

Your income is taxed at different rates at different levels. What did you say?! Bear with me. Let’s say your taxable income (whatever income is leftover after the standard deduction – or any other deductions – is subtracted) is $50,000 and your filing status is single. Here is how that income will get taxed:

• The first $9,950.00 of taxable income is taxed at 10% ($995.00 in taxes)
• The next $30,575.00 is taxed at 12% ($3,669.00)
• The last $9.475.00 is taxed at 22% ($2,085.00)

Okay, so that’s about $6,749.00 that you might owe in taxes. In this scenario, your marginal tax rate would be 22%, because that is the rate of the last dollar you were taxed. However, your effective tax rate, the amount you pay on your total income, is just 13.5% (because $6749.00 is 13.5% of $50,000).

Tax Preparation Assistance

There you have it; five key terms to help you understand your taxes better and get you ready to file away! If you are not quite ready to figure it out on your own, don’t worry. Tax preparation assistance is available! Check out free filing programs at the IRS website, visit your local Volunteer Income Tax Assistance (VITA) location if your household earns under $54,000 a year, or find your local Tax Counseling for the Elderly (TCE) location for free help in filing taxes. Individuals, families, and small business owners in Minnesota who earn under $55,000 ($35,000 for individuals) can meet with our friends at Prepare and Prosper for free tax help.

Tax time is a good time to revisit your financial goals for the year, which starts with a budget. LSS Financial Counseling can work with you to create a realistic budget to help you achieve your goals. Our certified, nonjudgmental financial counselors can also provide support with budget planning and specific steps to take regarding tax payments or ideas to most effectively use a tax refund. Call us at 888.577.2227 to schedule a free and confidential appointment, or make an online appointment.

Author Shannon Doyle is a Program Manager with LSS Financial Counseling.