Decoding Tax Abbreviations

Understanding taxes is complicated, more so by the fact tax pros and the IRS often use abbreviations to denote various tax terms. To better utilize tax breaks and opportunities, it’s helpful to know what those abbreviations stand for. Here are some common ones to help you get started.

General terms

If you’ve ever looked closely at your tax return, you’ll see there’s a line labeled adjusted gross income (AGI). This is your gross income minus certain “above-the-line” deductions (such as alimony payments, IRA contributions [you probably know IRA means individual retirement arrangement], and moving expenses) you can take whether or not you itemize other personal deductions. AGI is used as a limitation or threshold for certain tax rules, such as the dependent care credit.

What you don’t see on the form is the term modified adjusted gross income (MAGI). No, it’s not a group of wise men. It’s AGI with certain adjustments. MAGI is used through the tax law as a limitation or threshold for various tax purposes. For example, your ability to make Roth IRA contributions is based on MAGI. Next year, your obligation to pay additional Medicare taxes on earned income and net investment income is also based on MAGI. The confusing thing about MAGI is that it doesn’t mean just one thing. Different adjustments apply for different tax rules. Usually, MAGI is AGI with the foreign earned income exclusion added back. But MAGI can also require other add-backs for different tax purposes.

One of the most dreaded terms in tax law is AMT, which stands for alternative minimum tax. It is a tax that’s triggered when certain tax breaks bring your income down below a fixed level and is designed to ensure that all filers pay at least some (or minimum) tax.

Health care terms

Hey, what’s an HSA (which stands for health savings account)? This is a type of health care plan that combines a high-deductible health plan (yes, another abbreviation—HDHP) with an IRA-like account. Altogether, an HSA is a way to obtain affordable health coverage.

Don’t confuse HSAs with MSAs, which are Archer Medical Savings Accounts (Bill Archer is the Congressman who sponsored this rule). These accounts are an alternative to HSAs, but can be used now only by individuals and self-employed individuals who set them up prior to 2008.

And don’t think these are the only health plans you may encounter. An FSA (flexible spending arrangement) is a plan funded by employees’ salary reduction contributions up to a dollar limit ($2,500 in 2013). This enables employees to pay their out-of-pocket medical costs on a pretax basis.

Some employers offer their staff a Health Reimbursement Arrangement (HRA). This plan also covers employees’ out-of-pocket medical costs, but employees don’t make any contributions. Qualified costs are paid by employers, who set their own annual cap on reimbursements. Unlike FSAs, unused amounts in HRAs can be carried over to the following year. The funds are lost when an employee leaves the company.

Retirement terms

So you already know IRAs. But when you inherit one or own one reach age 70¹/₂, you’ll need to understand required minimum distributions (RMDs). The law aims to have you drawn down and pay taxes on the account essentially over your lifetime. If you fail to withdraw from the account or plan the minimum amount, you’ll owe a draconian 50% penalty.

When a taxpayer who participates in a qualified retirement plan, such as an employer’s 401(k) plan, gets divorced, the spouse has certain rights in those benefits. If they are paid to the spouse, they are usually taxable to the participant. However, the tax obligation can be shifted to the spouse who receives the benefits by obtaining a QDRO (Qualified Domestic Relations Order). This court order tells the plan administrator who, when, and how much to pay benefits to.

If you are in business and want to use a retirement plan that doesn’t entail a lot of administrative work and annual government filings, you can opt for a:

• SEP (Simplified Employee Pension) plan, which lets you add up to 25% of compensation (effectively 20% if you’re self-employed)
• SIMPLE (Savings Incentive Plan for Employees) plan is like a mini-401(k) which is funded primarily by employee salary reduction contributions.

Other terms

This brief survey of tax abbreviations is by no means the complete picture of those you may see or hear about. Here are some other key terms:

• APR—applicable federal rate is the Treasury-set interest rate for short-, mid-, and long-term loans and is used to compute interest on interest-free and below market loans.
• EFTPS—the Electronic Federal Tax Payment System is a free government service that enables you to transfer funds from your bank account to pay your taxes.
• NOL—A net operating loss is an accumulation of losses from business or casualties that can’t be used in the current year but can be carried back and forward to certain years to offset income in those years.

Conclusion

Learn to decode tax terms so you can better understand what tax advisors and the IRS are talking about.