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By April 15 of each year, Americans typically must file their tax returns with the Internal Revenue Service (IRS). As the name suggests, income tax requires individuals and businesses to pay a percentage of their earnings or profits from the previous calendar year to the government.
Figuring out the right amount to pay can take some time. When you or your tax preparer fills out your tax forms, you’ll find out if you’ve overpaid your taxes, meaning you’re entitled to a refund, or if you’ve underpaid, which means you’ll owe money to the government.
There are different types of income tax, but the most common one people have to file is federal, which is done through the IRS, a bureau within the U.S. Treasury Department. Depending on where you live, you may also have to pay state or local income taxes.
Here are key things to know about income tax, including how it works, how to determine what you owe, and possible ways to reduce your taxable income and save on taxes.
Key Points
• Income tax is a mandatory payment to the government based on an individual’s or business’s annual earnings or profits.
• The U.S. tax system is progressive, meaning higher income generally results in a higher overall tax rate.
• The amount of income tax you based on your gross income, adjusted gross income, and deductions (either standard or itemized).
• You can potentially lower your taxable income by contributing to pre-tax accounts like a 401(k) or HSA.
• You typically need to file your income taxes by April 15 each year; extensions are available for filing but not for payment of taxes owed.
What Are Income Taxes?
Income taxes are taxes that are collected by the government on income (aka money) earned by individuals and businesses. This can include salaries, tips, commissions, bonuses, investment income, interest earned, and other sources. Income tax can be assessed by a federal, state, and/or local government. Some Americans may only pay federal taxes; others may be liable for taxes at a federal, state, and local level.
Once collected, taxes are typically used to fund a wide array of public services, programs, and government operations at the national and local level.
How Does Income Tax Work?
The amount of income tax you pay depends on how much money you’ve earned in the past year as well as your filing status (e.g., single, married filing jointly, etc.), along with other factors. First, a bit more about what counts as taxable money:
• Income that’s taxable includes your earnings from work, interest earned on savings accounts, and money made from investments or rental properties.
• Certain forms of income may not have to be reported on your tax return. Some examples of income that may be nontaxable include child support payments, financial gifts, alimony, and employer-provided health insurance.
The U.S. tax system is progressive, which means the greater your income, generally the higher your overall tax rate. The idea behind a progressive system is that people who earn more are typically able to pay more in taxes.
Currently, there are seven tax brackets, ranging from 10% to 37%. Each bracket corresponds to specific income thresholds and are adjusted each year for inflation.
Tax season revolves around filing income tax returns each spring. Some details:
• The typical deadline is April 15, though if that date falls on a weekend or holiday, the date will be moved to the next business day.
• Those who are self-employed may pay quarterly estimated taxes.
• You must file your federal income tax return with the IRS, by mail or electronically. In order to file, you must have all the necessary year-end income documents, including those from your employers and financial institutions.
• The IRS recommends taxpayers file electronically, since it can take six weeks or more to process a paper return. Electronic files move much more quickly through the system.
When you fill out your tax return and file it with the IRS, you’ll find out if you’ve underpaid and still owe any taxes or if you’ve paid too much and are entitled to a refund. Salaried workers must complete an IRS Form W-4 to help their employer withhold the correct amount of federal income tax from their paychecks. This form can be changed to help correct for too much or too little taxes withheld during the previous year.
Brief History of How Income Taxes Came to Be
Now that you know what income tax is, here’s a quick look at how it came into being in America. The first federal income tax came about in 1861 as a way to finance the Civil War effort. A year later, Congress passed the Internal Revenue Act which created the Bureau of Internal Revenue, which eventually evolved into today’s IRS. But income tax didn’t have substantial support after the Civil War and was repealed in 1872.
Federal income tax made a short comeback in 1894, but the next year it was ruled unconstitutional by the Supreme Court. This verdict was based on the grounds it was a direct tax and not apportioned among the states on the basis of population.
In 1909, the 16th amendment to the Constitution was introduced, which would give the government the power to collect taxes without allocating the burden among the states in line with population. It was passed by Congress then, but it still needed to be ratified by 36 states. Ratification of the 16th amendment finally happened in 1913, giving Congress the legal right to impose a federal income tax. This laid the foundation for the tax system as it’s known today.
What Are the Different Types of Income Taxes?
Income taxes are primarily categorized based on who pays them (individuals or corporations) and the source of the income, such as wages, investments, or business profits. Here are some common types of income tax:
• Individual or personal income tax. This type of tax is imposed on salaries, wages, investment earnings, or any other forms of taxable income a person or household earns. Thanks to deductions, tax credits, and exemptions, most people don’t end up paying taxes on all their income.
• Business or corporate income tax. This kind of tax is based on business profits, minus the costs involved in doing business. According to the IRS, all businesses except partnerships must file an annual income tax return.
• State and local income tax. Depending on where you live and work, you may have to pay state and local taxes. Currently, nine states (Alaska, Florida, Nevada, South Dakota, Texas, Tennessee, Washington, Wyoming, and New Hampshire) don’t have a state income tax. Some local governments impose a local income tax on people who live or work in a specific city, town, county, municipality, or school district. Both state and local taxes help pay for a wide range of services like roads, schools , and law enforcement. State and local taxes are generally much lower than federal income tax.
How Do I Know How Much I Owe in Income Taxes?
In order to figure out how much income tax you may owe, here are some steps:
• You’ll want to know your filing status which will determine which tax bracket you fall under. The five filing status choices are single, married filing jointly, married filing separately, head of household, and qualifying widow(er) with dependent child.
• Once you know how you’re going to file, you’ll need to gather up all your documents detailing your earned income, such as your W-2 and 1099 statements. When you have all of the information about how much money you earned, you can total it up, which amounts to your gross income.
• The next step in knowing how much you owe in taxes is to calculate your adjusted gross income (AGI). You can do this by taking your total gross income from the year and subtracting any “above the line” adjustments, as they’re known, that you are eligible for. A list of adjustments to income can be found on Schedule 1 of Form 1040. They include, up to certain limits, educator expenses, the deductible part of self-employment tax, and student loan interest payments
Once you’ve got your AGI number, you can then subtract any standard or itemized deductions to get your taxable income amount. Itemized deductions may include charitable donations, paid mortgage interest, property taxes, and unreimbursed medical and dental expenses. An alternative to itemized deductions is the standard deduction option. A standard deduction is a set dollar amount based on your filing status. The vast majority of Americans take the standard deduction when filing their federal income taxes. When you have your taxable income number, you can then pinpoint your tax bracket and determine your tax rate.
Recommended: What Are the Common Types of Payroll Deductions?
Ways to Lower Your Taxable Income
You may be able to reduce your taxable income by taking advantage of any pre-tax savings opportunities available to you. Consider these tips:
• Take advantage of employer-sponsored retirement plans. Contributions to a 401(k) for example, are made with pre-tax dollars, meaning they lower your current taxable income, and you pay taxes later when you withdraw the money in retirement, potentially at a lower tax rate
• Enroll in a health spending account (HSA) or flexible spending account (FSA) if your company offers them. A health savings account allows pretax contributions to be used for upcoming healthcare costs for employees with high-deductible health insurance plans. If your employer doesn’t offer one, you can open a HSA on your own, provided you meet the eligibility requirements.
With a flexible spending account, you set aside pre-tax dollars from your paycheck to pay for eligible out-of-pocket healthcare or dependent care expenses. This can help you save money on taxes while covering costs like copays, prescriptions, dental, and vision care.
• Figure out what tax deductions you can claim. To save on taxes, you can claim a variety of deductions that reduce your taxable income. You have two main options: take the standard deduction (a fixed amount based on your filing status) or itemize your deductions if your eligible expenses are greater than the standard amount.
• Check that your tax withholding is appropriate. If you find that you owe a significant amount in taxes come tax day, or that you’re due a large refund, you may need to adjust your W-4 form. While a refund may seem like good news, it essentially means you’re giving the government an interest-free loan throughout the year. It’s also a good idea to update your W-4 form if you have a major life change, such as the birth of a child, marriage, divorce, or a significant pay raise.
Recommended: 7 Steps to Prepare for Tax Season
Tips for Filing Income Taxes Correctly
Avoiding mistakes when filing your tax return can help prevent you from missing out on a bigger refund than you claimed or triggering a tax audit by the IRS.
Here are some suggestions on how to fill out your tax return when filing whether you’ve done it before or are doing your taxes for the first time:
• Gather all of your pertinent paperwork and make sure you’re not missing tax forms. You’ll need a W-2 form from each employer, other earning and interest statements, and receipts for any expenses you’re itemizing on your return. Any income and investment interest forms should be mailed or sent electronically to you in January. If you haven’t received them in the mail, you can typically find and download these documents online through your bank, mortgage provider, or payroll company. If you still haven’t received your tax statements or can’t find them online, call the necessary people to get your documents as soon as possible.
• When filling out your return, make sure your basic information is accurate, such as your name, Social Security number, and filing status. The IRS will also be double-checking your numbers against your tax statement documentation.
• Take care when disclosing your income. Report your financial information exactly as it’s reported to the IRS on forms such as your W-2 and 1099s.
• Sign your tax return. According to the IRS, an unsigned tax return is invalid. If you’re married and filing jointly, in most cases both spouses must sign the form. Filing electronically can help taxpayers avoid submitting an unsigned form by using a digital signature.
• Consider using a tax preparation software program or having a professional tax preparer do your return. Online software is often fairly straightforward if your situation is pretty simple. However, if your tax return is more involved and complicated, it may be worth it to hire a tax professional. An experienced tax preparer can help ensure your tax return will be filed correctly and on time.
• Try not to put off filing your taxes until the last minute or you run the risk of missing the tax filing deadline.
• You can file for a tax extension of six months, but know that any taxes owed are still due on time; it’s the return that can be filed later.
The Takeaway
Income taxes are a way for the government to collect revenue from citizens and businesses. Besides paying federal income taxes, you may need to also pay state and local taxes. There are ways you may be able to lower your taxable income, and doing so may result in paying less in taxes or getting a bigger refund. Knowing how to file correctly and on time can help maintain your financial well-being.
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FAQ
Can I lower my income taxes?
Yes, you may be able to lower your income taxes by reducing your taxable income. You can do this by taking advantage of pre-tax savings opportunities, such as contributing to an employer-sponsored retirement plan (like a 401(k)), or enrolling in a Health Savings Account (HSA) or Flexible Spending Account (FSA). You can also lower your taxable income by claiming deductions. This could be the standard deduction or, if your eligible expenses are high enough, by itemizing deductions like mortgage interest or charitable donations.
How can I determine how much income tax I’m required to pay?
To determine how much income tax you owe, you first need to establish your filing status (e.g., single, married filing jointly) and gather all income documents like W-2s and 1099s to calculate your gross income. Next, you calculate your adjusted gross income (AGI) by subtracting eligible “above the line” adjustments. Finally, subtract either the standard deduction or your itemized deductions from your AGI to find your taxable income. This taxable income amount determines your tax bracket and your resulting tax liability.
Does income tax improve your money management?
Yes, understanding income tax can significantly improve your money management. By learning how tax brackets and deductions work, you can make informed decisions about your withholding (using Form W-4) to ensure you are not giving the government an interest-free loan through a large refund. In addition, taking advantage of pre-tax savings, like 401(k) and HSA contributions, is a key money management strategy that directly lowers your taxable income, helping you save money and invest for the future.
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