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A Few Basic Tax Terms That 'The Man' Doesn't Want You to Understand

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Tax termsIs the American tax code designed to be confusing?

Looking at the thing, it's hard to escape that conclusion. To begin with, there's its size: The full code is over 70,000 pages long -- 22 times as long as Remembrance of Things Past, 62 times as long as the King James Bible, and 54 times as long as the complete works of William Shakespeare. Or, to put it another way, it's about 175 times as long as its first edition, which was published in 1913.

Contained within its 3.7 million words are thousands of exemptions, definitions, deductions and loopholes, and teasing them out requires an estimated 7.6 billion hours of tax preparation per year. That's more than 24 hours for every man, woman and child in the country. Even the head of the IRS hires an accountant to do his taxes.

Given all that, it's hard to dismiss the notion that the tax code is deliberately designed to confuse the average taxpayer: Its byzantine structure supports an army of accountants and attorneys, computer programmers and bean counters who rake in an estimated $27.7 billion per year helping us prepare our taxes.

But the tax prep industry isn't the only group that benefits. Arguments about cuts and deductions, minimums and premiums have fueled many a political campaign. And whether you're inclined to raise tax rates or lower them, increase incentives or decrease exemptions, chances are that you've been tripped up at least once or twice by a confusing term -- or a slick politician wielding it. With that in mind, we decided to unpack a few of the most weaselly of the IRS's weasel words -- and look at how they may affect your yearly taxpaying ritual.


Income vs. Taxable Income

James RossOne of the most slippery tax phrases is income. Taken at face value, its definition seems obvious -- clearly, "income" is supposed to refer to the amount of money that a worker brings home in a year. But in the hands of the tax industry, even this clearest of words becomes cloudy. Recently, The New York Times highlighted this with its tale of the ridiculous tax rate paid by James Ross (right). The founder of an investment firm, Ross paid 102% of his 2010 income to the taxman.

The tale was tailor-made for tax critics: Ross -- a job-creator, a graduate of Yale and Columbia, and a one-man economic powerhouse -- was clearly being charged a cruel and unusual tax rate. How could the government possibly rob such an upstanding citizen like that? Where do we live, Sweden? By God, Ross had to withdraw money from his savings account to cover his taxes!

Of course, there was more to the story. Ross didn't actually pay 102% of his income, but rather 102% of his taxable income -- the money left over after he subtracted out his mortgage interest, state taxes, and all the other clever deductions and exemptions he was allowed to take from his total income. In fact, Ross actually paid only 20% of his real earnings in 2011 -- about 4 percentage points less than the average tax paid by someone at his level. Thanks to his impressive list of deductions and business-related expenses, he actually scored a nice tax cut, rather than the brutal burn that the Times story would at first seem to suggest.

Income should be an straightforward, clear term, but it's often muddied for political purposes. Total income -- the amount of money that one makes in a year -- can be hard to quantify, so pundits and politicians tend to focus on more easily-defined terms. For example, depending on a politician's leanings, he or she may consistently discuss earned income (all the taxable wages and tips that one gets from a job), adjusted gross income (earned income, minus personal exemptions), or taxable income (earned income, minus all exemptions and all deductions). Because wealthy people often have more deductions and exemptions than lower-level earners, changing which term you use can radically alter how you frame any tax debate -- not to mention the degree to which the rich seem to be unfairly targeted by the tax code.


Dividends: Qualified to Cause Trouble

By all rights, a dividend should be easy to understand: It's money that a company pays out to its stockholders, and for most of the modern era, it was generally taxed at the same rate as any other income. Beginning in 2003, however, special tax breaks for stockholders muddied the waters, turning a relatively simple idea into a complicated -- and controversial -- tax nightmare.

Tax terms

Nowadays, there are two basic classes of dividends -- "ordinary" and "qualified." Ordinary dividends, which come from stocks that have been held for a short period of time, are taxed at the same rate as ordinary income. "Qualified" dividends, on the other hand, come from stocks that have been held for longer periods, and are taxed at a much lower rate.

The differences between the rates are major. People who earn up to $33,950 per year pay a basic tax rate of 10% to 15%. But people who make that money from qualified tax dividends don't pay any tax on it at all. Meanwhile, those who earn more than $33,951 per year pay between 25% and 35% on their taxes, but those who get that money from qualified dividends pay only 15%. This, by the way, explains how tycoons like Mitt Romney and Warren Buffett reach overall tax rates of 15% or lower, while people who make $34,000 per year pay a base rate of 25%.

While the qualified dividend tax rate is attractive, it is also confusing: The IRS' rulebook states that qualified dividends must come from stocks that the owner has held "for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date." But there's also qualified preferred stock, which must have been held "more than 90 days during the 181-day period that begins 90 days before the ex-dividend date if the dividends are due to periods totaling more than 366 days."


Interest Gets Too Interesting

As if dividends weren't confusing enough, some things classed as "dividends" are actually misnamed -- and are taxed as regular income. For example, the "dividends" that you get from your credit union or savings and loan bank are actually classed as interest. This money counts as regular income, and is taxed as such.

(Of course, interest income isn't a huge problem these days. As long as the Federal Reserve keeps its interest rate at or near zero, most financial institutions aren't going pay much interest to their customers. This, incidentally, is part of why banks have been piling on fees and charges over the last few years. But that's another story.)

Interest itself is another tax oddity. For example, in the current election cycle, something called "carried interest" has come under scrutiny. Essentially, it's a payment method used by many hedge funds and investment firms that pays fund managers and execs out of the proceeds of the funds they manage. By linking paychecks directly to investment income instead of salary, carried interest enables these high-earners to pay a 15% tax rate instead of the 35% that wage earners pay. President Obama's 2013 tax proposal suggests that Congress close the carried interest loophole.

But even regular interest can be confusing. The interest that one gets from a standard bank account, CD or money market account is taxed at the same rate as regular income, but interest from a savings bond doesn't count until the bond matures or until you redeem it. And, if you use your savings bond interest to pay for some of your college expenses, you may be able to avoid paying taxes on it.

If you own U.S. Treasury bills, notes or bonds, the interest that you get from them is subject to federal tax, but not to state tax. On the other hand, interest on bonds that are issued by states may be exempt from federal tax! For that matter, some of the interest you pay -- specifically the interest on your mortgage and your student loans -- may be deductible.


Bruce Watson is a senior features writer for DailyFinance. You can reach him by e-mail at bruce.watson@teamaol.com, or follow him on Twitter at @bruce1971.


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undescribable

miserabloldefart you sound so cold, you seem as if you if feel slighted somehow by the government like they owe you something, but on the other hand don't agree with how they do either. not bashing you in any way, just an observation of what I picked up. it's is an utter shame that our country has become what it has, but it will never change unless people start trying to make changes instead of trash talking or even flaunting what you can get for free at the expense of others. my personal opinion is that the big issues will more than likely never change because that would mean the government changing the tax laws & so many other things that are wrong in our now corrupt government that are continually making them very, very wealthy. why would they change that unless they were forced to?

March 15 2012 at 4:48 PM Report abuse rate up rate down Reply
miserabloldefart

America has one of the lowest overall taxation rates of any industrialized nation. At the same time, our "defense" spending is about equal to the rest of the world combined. The obvious solution is to repeal the tax cuts for the rich enacted under raygun and bush and cut military spending to 2000 levels. These two actions alone will decrease the deficit by well over a half TRILLION dollars per year, and the USA will STILL have one of the lowest tax rates of any industrialized country.

February 25 2012 at 1:44 AM Report abuse +1 rate up rate down Reply
papadon.don

what's in a name??... the big $$ we are forced to pay is bad enough ... This years TurboTax got me thru several new Forms and regulations, only to punish me with an unhappy ending. I've been preparing tax returns for 50 years... and I gotta say... ain't NOBODY can do a 1040 and a couple of schedules by hand anymore... the maze of silly forms is interactive... ya gotta use software. Ah, YOUR idiot Govt at work!!

February 24 2012 at 11:17 AM Report abuse -1 rate up rate down Reply
mpusairsret

There's no news in this article. All the terms have been around for years and the definitions have not changed.

February 20 2012 at 6:37 PM Report abuse +1 rate up rate down Reply
Neil

Writer Bruce Wilson, in discussing Income, can't even get it straight. He wrongly defines Adjusted gross income (AGI) as earned income minus personal exemptions. Not so. The AGI is the total of income from numerous sources minus deductions, not income minus personal exemptions. But then, this is just symptomatic of the impossible tax tax we have.

February 20 2012 at 6:28 PM Report abuse rate up rate down Reply
Neil

Writer Bruce Wilson, in discussing Income, can't even get it straight. He wrongly defines Adjusted gross income (AGI) as earned income minus personal exemptions. Not so. The AGI is the total of income from numerous sources minus deductions, not income minus personal exemptions. But then, this is just symptomatic of the impossible tax tax we have.

February 20 2012 at 6:28 PM Report abuse rate up rate down Reply
bbarl57849

What a stupid article, just used to fill space because something has to. Just add to the confusion why don't you. Most of the people are not affected by these issues and those that are, pay somebody to sort it out. This comes from the approach that "oh, my god now i have to pay taxes on these things". If you've been doing it, changes are gradual and if you don't then have somebody help you, even the tax prep software works for your education.

February 20 2012 at 1:36 PM Report abuse -1 rate up rate down Reply
miserabloldefart

The righties hate this article because it shows that this country's taxes attack and exploit the poor and working class, which are, thanks to the fraudulent economic policies of the radical right corrupting America for the past three decades, increasingly one and the same.

States rely heavily on sales taxes which are heavily regressive. Their income tax programs are barely progressive if they are progressive at all. Ergo, states hit the working poor with an unfair tax burden. This is a fact - it's Econ 101. Even the dumbed down, drooling idiots that believe FOX and the other corporate media channels can count on their fingers and toes and see that this is true. The result is that they get slobbered up an attack anyone who dares to present the truth.

This country had its greatest success when taxes were progressive, unions were strong and corporations had limited control over the government. Now that the government is under the jackboots of the corporate overlords, taxes are regressive, and the rich are accumulating ALL of the wealth and resources of the country, leaving 90% of the people to fight over the scraps, America is in a death spiral - and the Amerikan right continues to make it worse.

February 20 2012 at 10:15 AM Report abuse -2 rate up rate down Reply
JOSEPH

Has the tax code ever not been confusing?

February 20 2012 at 9:00 AM Report abuse +2 rate up rate down Reply
miserabloldefart

Another nice version..

http://www.youtube.com/watch?v=V7awW5nrDHk

February 19 2012 at 4:26 PM Report abuse rate up rate down Reply