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Tax terminology is important to know but confusing to understand, so we’re explaining 10 words we see often but tend to confuse or simply don’t know much about

What’s a tax credit? Itemized deduction? The difference between income tax withheld and income taxes? All I want to do is file my taxes — why do all of these words look the same and sound so complicated?

Hey, it’s your premier accounting firm Prospect Financial Solutions here! First, take a breath. Second, don’t kill your brain worrying about the meaning of certain tax terms. It’s a lot and trying to figure it all out on your own might only cause more stress.

As accountants, bookkeepers, small business owners, tax payers, and people who enjoy our money, we understand the many frustrations when it comes to filing taxes, especially since the words used on the forms aren’t common to non-accountants. So, let’s simplify these terms in a way that you’ll actually understand (and let’s make next year’s tax filing a bit more of a breeze).


1. Capital Gains

Sure, we could all benefit from going to the gym to make some gains, but this isn’t that type of conversation. A capital gain in the tax world is one type of earning that counts toward your gross income.

You earn capital gains when the sale price of an asset is higher than the initial purchase price and as noted above, it’s considered a form of income. Say you purchased a vintage car for $3,000, spent $2,000 restoring it, and sold it for $6,000. You made a grand of profit, i.e. capital gains, on that sale – nice job! Before you go spending all that profit, be aware you’ll have to pay taxes on it. The same principle applies if you buy stock for $5,000 and sell it for $6,000.

2. Form 10401 vs. Form 1040EZ

The IRS requires that U.S. residents file a tax return every year. Doing so allows the IRS to ensure that you’ve paid the correct amount of taxes on your income throughout the year. Form 1040 (from 2017 to 2021) is the official tax document used by individuals to file tax returns with the IRS in the USA that should be submitted by the annual tax filing deadline each year, usually on April 15th. In many cases, individuals pay more than they owe through payroll deductions, and as a result receive a refund after filing their Form 1040 with the IRS.

In general, you’ll use the standard Form 1040 if you are making itemized deductions, make more than $100,000 per year, or are claiming dependents on your tax return.

Form 1040EZ is a document used to file your legally required annual federal income tax return to the Internal Revenue Service (IRS) in the United States. In fact, it’s the shortest, simplest tax form, and therefore probably the fastest way to file your taxes.

The catch? Not everybody is eligible to use the 1040EZ, so you’ll have to figure out whether or not you are before using it. You need to meet the following criteria:

  • You must have a taxable income for the tax year of under $100,000.

  • You cannot claim dependents on your tax return.

  • You must have a taxable interest of under $1,500 for the tax year.

There are some additional criteria that must be met in to qualify for using the 1040EZ, but these are the main ones you need to meet. And, fortunately for the majority of the population who find federal taxes and tax preparation rather perplexing, the 1040EZ form is designed specifically to make the process as easy as possible. It’s generally fairly straightforward to follow, so most users will not have many issues.

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3. Itemized Deductions

These are expenses that can be deducted from your AGI to help you reach a smaller income amount upon which you must calculate your tax bill. Itemized deductions include medical expenses, other taxes (state, local and property), mortgage interest, charitable contributions, casualty and theft losses, unreimbursed employee expenses and miscellaneous deductions such as gambling losses. Some itemized deductions must meet IRS limits before they can be claimed. When you itemize, you must file Form 1040 and detail your tax deductions on Schedule A.

4. Charitable Contribution

What constitutes something as being a charitable contribution according to the government? Well, acting as your best friend’s wingman isn’t going to save you any money at tax time (sorry, but we appreciate the charitable efforts and we’re sure Best Friend does, too).

A true charitable contribution by government standards is a type of itemized deduction that can earn you an itemized tax deduction; donate to a qualifying non-profit organization, charity, or private foundation and you can qualify. These gifts are commonly made in the form of cash, but can also include real estate, clothing, appreciated securities or other assets.

To determine if the organization that you have contributed to qualifies for income tax deduction purposes, refer to the IRS’s Exempt Organizations Select Check tool.

5. Tax Deductions

Not to be confused with tax credits (see below). Tax deductions are subtracted from your taxable income. The impact of your deductions ultimately depends on the marginal tax bracket that you fall into. In other words, let’s say you have a $2,000 deduction. If you’re in the highest marginal tax bracket (39.6%) that deduction saves you more than it saves someone in a lower tax bracket. That’s why tax credits can be more beneficial to lower- and middle-income taxpayers.

6. Tax Credits

Not to be confused with tax deductions (see above). Tax credits directly lower your tax bill and their value isn’t affected by tax brackets. So a $2,000 tax credit is worth the same ($2,000) to a person in the 15% tax bracket as it is to an individual in the 33% bracket. In addition, if you qualify for a refundable tax credit you could come out ahead at tax time. With a refundable tax credit, the amount of the credit minus the amount you owe the IRS is the money you’ll get to keep. Score!

Related reading(s): 10 Tax Form Terms You Could Be Confusing

7. Bracket2

In the U.S., the IRS uses a progressive tax system, meaning taxpayers will pay the lowest rate of tax on the first level of taxable income in their bracket, a higher rate on the next level, and so on.

Currently, there are seven federal tax brackets, each assigned a different rate, ranging from 10% to 37%, with the dollar ranges in each varying for single filers, married joint filers (and qualifying widow(er)s), married filing separate filers, and head of household filers, resulting in 28 effective tax brackets.

Taxation progressively increases as an individual’s income grows. Low incomes fall into tax brackets with relatively low income tax rates, while higher earnings fall into brackets with higher rates.


8. Allowances

An allowance determines the amount of income you’ll have withheld from your paychecks and turned over to the IRS. The more allowances you claim, the less you’ll have taken out of your paychecks.

You can claim allowances on your W-4 form for yourself, your spouse and your dependents. The number of jobs you have and the amount of income you’re earning also come into play. If you claim too many allowances, you could end up owing extra taxes. When you don’t claim enough, you stand to receive a tax refund.

9. Dividends

Dividends are payments, usually earnings, from a company to certain shareholders. Generally. companies must declare dividends before paying them. This is typically authorized by the company’s board of directors.

You may receive dividends if you own stocks, mutual funds, or exchange-traded funds (ETFs) that have stocks as a holding in the fund.

  1. Qualified: A qualified dividend is taxed at the capital gains tax rate, while ordinary dividends are taxed at standard federal income tax rates. Qualified dividends must meet special requirements put in place by the IRS.
  1. Unqualified: An unqualified dividend (sometimes referred to as “nonqualified dividend”) is one that doesn’t meet the IRS’s requirements to qualify for a lower tax rate. These dividends are also known as ordinary dividends because they get taxed as ordinary income by the IRS. Unqualified dividends include: Those paid by certain foreign companies.

Related reading(s): Taxes on Ordinary, Qualified Dividends

10. Exemptions

Exemptions are types of deductions that you claim on your income tax return to lower the amount of your money that’s taxed. Like allowances, exemptions can be claimed for your children, your husband or wife and for yourself. Income determines who’s eligible for personal exemptions. Other exemptions are available for qualifying organizations and businesses.


Taxes can be very confusing to the uninitiated. Unless you’re a trained accountant or have a struggled through it in the past, the whole process is many people’s idea of hell. However, it doesn’t have to be as complicated as you may think.

Still have questions? We’ve got answers. Contact us for all your tax and accounting needs and struggle no more during tax season!