How Do Income Taxes Work?
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Taxes, agh! Who likes them? Well, certainly not paying them, but taxes (as hard as it is to believe sometimes) do play a big role in the day to day of the United States. Most everything you see out there was fully or partially funded by your federal taxes, which is why the IRS plays hardball when it comes to collecting them. But how do income taxes work?
Omnipresent as they are in the lives of almost every American, taxes are still very much misunderstood, and many myths surround them to this day. In this guide, we’ll attempt to explain what taxes are and how they work, and hopefully dispel a few of those myths along the way.
What Are Income Taxes and How Do They Affect You?
For most people, the thought of paying income taxes makes their stomach turn. While everyone knows that income taxes are paid to the IRS (Internal Revenue Service) each year, the process of taxation itself can be confusing to many. There are various factors that affect how your personal income is taxed, as well as how much you end up paying to the government or receiving back as a tax refund.
The United States government needs a lot of money in order to function and fund its numerous foreign and domestic programs. Americans are becoming more and more aware of how their tax dollars are spent, but many are still intimidated by the complexities of the taxation process. In a nutshell, individuals are expected to report their yearly income and pay income taxes accordingly.
Both individuals and companies are required to remit a portion of their income to the federal government on an annual basis. If/when politicians decide that they want more money for certain programs, they often raise income taxes to pay for them.
Here’s a short list of the different things funded by federal income taxes:
- First and foremost, for building, repairing, and maintaining infrastructure.
- Funding our multiple defense and national security programs.
- Providing safety net programs for lower-income citizens, as well as emergency disaster relief.
- Education, health, agriculture, cultural, public transport, and many other programs and grants are funded directly by federal taxes.
- Subsidies to the health sector is also funded by taxes.
- Social security programs, as well as pensions and benefits for government workers.
While legislators construct and implement tax laws, the IRS is the federal agency in charge of enforcing those tax laws and collecting the taxes. The IRS also provides assistance to taxpayers who have questions, concerns, or issues with their tax situation. Due to advancements in technology, many tax preparation and filing services are now available online.
Payment methods have also come a long way since the times of standing in line outside the post office with a fat wad of cash under your arm (or carrying a check with a bunch of zeroes). From Direct Pay to electronic wallets and direct bank deposit, and even retail partners, the IRS has made tax payment as accessible as possible for every taxpayer (provided their tax return is filed correctly).
Federal Income Tax Brackets & Tax Rates
The amount of income tax that you owe each year is based on your income level. The United States currently uses a progressive income tax system — which means that the more money you earn, the more taxes you have to pay. Fortunately, there are ways you can reduce your income tax liability by using various tax credits, tax deductions, tax exclusions, and other tax breaks.
The majority of individuals are subject to the “Pay-As-You-Go” system, which means that their income tax is deducted from each paycheck and sent to the IRS. This is also referred to as withholding tax. If you are self-employed, the IRS expects you to pay income tax on a quarterly basis (typically in equal installments every three months) via estimated tax payments; this is because standard withholding like regular employees have is not an option for self-employed taxpayers (even if they also work a regular job on top of their self-employment).
At the end of the year, if your payments were not enough to cover the total income tax due, you must pay the rest to the IRS by April 15. Conversely, if you paid too much over the course of the year (i.e. more than what you owe in income tax), the IRS will send back your excess payment in the form of a tax refund.
Marginal Tax Rates
Your marginal tax bracket is the highest tax rate that you will pay on your income. For the 2024 tax year, there are currently seven income tax brackets for each federal filing status: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The amount of tax you owe depends on your income level and filing status.
The marginal tax bracket system is a gradual tax schedule, which basically translates to this: as you make more money, you pay more tax. The amount of taxable income that you earn determines which tax bracket(s) you fall into. While it is the goal of many taxpayers to keep their income in the lower tax bracket, remember that the gradual tax schedule ensures that not all of your income is taxed at a higher rate.
For example, if you move from the 22% tax bracket to the 24% tax bracket, you may think that all of your income is taxed at that higher rate. However, only the money that you earn within the 24% bracket is taxed at that rate.
Federal Income Tax Returns: How Do Income Taxes Work?
Most U.S. citizens will need to file a federal income tax return every year and determine how much they owe in federal income tax. While the majority of people are required to file and pay income taxes, there are certain low-income earners (as well as children) who are exempt. You will most likely have to file an income tax return, but you should check the IRS’s filing requirements before you proceed.
Most people can simply review their W-2s (Wage and Tax Statements) to determine their annual income, although this can get slightly more complicated if you have worked more than one job during the year. For people who have different forms of earned income, they will have to report and back up all of them. The following are just some of the most common forms of earned income (but trust us on this, there are many more):
- All forms of wages from both salary and hourly pay.
- Pensions and retirement benefits.
- Fringe benefits such as sick pay.
- All self-employment income (which also requires you to pay quarterly income estimates).
- Unemployment benefits.
- Dividends from investments.
- All manners of business operations income.
Are Taxes Still As Complicated As Ever?
In June 2018, the IRS announced it was taking steps to streamline and simplify the income tax return process. This overhaul was part of the Tax Cuts and Jobs Act (TCJA), which was signed into law by President Trump on December 22, 2017.
Some tax return forms, including Form 1040A and Form 1040EZ, have been eliminated altogether starting with tax year 2019. The old Form 1040 (a.k.a. “the long form”) was replaced by a condensed, postcard-sized version that all taxpayers will use – with additional schedules/forms to attach if needed.
The simplified Form 1040 consolidates the three older versions of the 1040 return (Forms 1040, 1040A, and 1040EZ) into one form. The new 1040 form is basically two half-pages. The first page is where you provide your personal information – such as your name, Social Security Number (SSN), address, dependents, and signature. The second page is where you report your income, tax deductions, tax credits, and tax refund information.
State Income Taxes
State income taxes are separate from the federal tax laws enforced by the IRS. State taxes are levied by each individual state government – there is no system that encompasses the separate taxes for all 50 states. For this reason, state taxes will vary (sometimes greatly) based on where you live, shop, invest, work, and conduct business. State taxes may be administered by a department of revenue, department of taxation, state treasurer, or state comptroller.
Understanding Income Tax: FAQ
1. What are income taxes?
In a nutshell, income taxes are levies or charges that the federal government imposes on individuals and businesses based on their yearly income. These charges are calculated using the “taxable income” of taxpayers, which is their total gross income after subtracting a series of deductions and exemptions.
2. What’s the difference between gross income and taxable income?
Your gross income is the total amount of money you earn in a given tax year. This income is made up of all your revenue sources, such as salaries, wages, interest paid to you, dividends from investments, tips, and many more. After subtracting all applicable deductions and exemptions from your gross income, you’re left with your taxable income. It is the taxable income and not the gross income from which taxes are calculated and then taken.
3. How is income tax calculated?
The IRS (Internal Revenue Service), the arm of the federal government in charge of tax collection, applies different tax rates to your taxable income after dividing it into portions called “tax brackets”. Each tax bracket has a corresponding tax rate, and only the part of your income that falls into each bracket is taxed using the corresponding rate.
4. How do tax brackets work?
The IRS uses brackets to divide your taxable income into ranges, and each range is tied to a specific tax rate. Let’s say your taxable income for the year is $10,000, and the first three tax brackets are 5%, 10%, and 15%. Now imagine that the income range for each bracket is a clean $4,000; this means that your first $4,000 would be taxed at 5%, your next $4,000 at 10%, and your remaining $2,000 (which is the only amount that reaches the third bracket) is taxed at 15%. Therefore, even if you reach a higher tax bracket, only a fragment of your overall taxable income uses that bracket’s tax rate.
5. What is the difference between tax deductions and tax credits?
A deduction will reduce your taxable income, meaning that the amount of income that will be subject to taxes is lower; for example, a $1,000 deduction on a $10,000 taxable income means that, instead of $10,000 being taxed at 15%, now only $9,000 will be taxed at 15%. On the other hand, tax credits directly reduces your tax liability (that’s the amount of money you owe), dollar for dollar; getting a $1,000 credit means you have to pay $1,000 less in taxes.
6. Does being married mean I pay less taxes?
In essence, yes. That’s because your filing status determines a few factors such as your tax brackets, the amount of your standard deduction should you choose it, and your eligibility for certain credits. Married people get a better deal on taxes overall if both spouses choose to file a single tax return, but it’s not the only way to significantly reduce your taxable income.
7. Do self-employed people pay employee or business taxes?
Self-employed people pay self-employment taxes. This is a special category that includes things such as Social Security and Medicare contributions on top of their income tax. However, they are also subject to quarterly tax payments on their estimated income since they don’t have the option of withholding their own wages like a boss does for regular employees.
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