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Income Tax: What Is It and How Does It Work?

By Marcy Lovitch · February 14, 2023 · 12 minute read

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Income Tax: What Is It and How Does It Work?

Every year by April 15, give or take a day, most Americans file their tax returns. Income tax is exactly what it sounds like: Individuals and companies are typically required to pay taxes on their income, or the earnings and profits made during the previous year.

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 one most people have to file is federal, which is done through the Internal Revenue Service (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 as well.

Filing taxes can be confusing and complicated, but read on for a guide that will clarify:

•   What is income tax?

•   What are the different kinds of income tax?

•   How do you know how much you owe in income taxes?

•   How can you lower your taxable income?

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. Also know that what is an 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 those at a federal, state, and local level.

What are income taxes used for once they are collected? Taxes are typically earmarked to pay for public services, provide goods for citizens, and also go toward government needs. Infrastructure is a common use; that means things like building roads, improving education, and the like.

Income taxes may be collected at the federal, state, and local level, depending on where you live.

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 other factors, such as whether you are single or the head of household. First, a bit more about what counts as taxable money:

•   Income that’s taxable includes your earnings from work, rental properties, or money made from stock investments.

•   Certain forms of income that are deemed nontaxable and may not have to be reported on your tax return. Some examples of nontaxable income are child support payments , financial gifts, alimony, and employer-provided health insurance.

The U.S. tax system is progressive, which means the greater your income, the higher your tax rate. The idea behind a progressive system is that people who earn more are able to pay more in taxes. So, depending where you fall income-wise, you’ll be taxed at a different rate.

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 months 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 file an IRS Form W-4 with their employer spelling out their tax withholding, or allowances. This indicates how much to set aside from a paycheck for taxes. This number can be changed to help compensate for too much or too little taxes paid out during the previous year.

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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 the 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?

There are three basic types of taxes: taxes on what you buy, taxes on what you own, and taxes on what you earn. Under the umbrella of the latter, or earned income, there’s individual or personal income tax, business income tax, and state and local income taxes. Here’s the differences between them:

•   Individual or personal income tax. This type of tax is imposed on salaries, wages, investments, 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.

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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 the Schedule 1, 1040 IRS form and include deductions such as educator expenses, 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 can 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. 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 can 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 before tax. This removes the contribution amount from your taxable income and can thereby lower the amount of taxes you’ll have to pay for the year. You can also take an individual retirement account (IRA) deduction if you contribute, which can also lower taxes owed.

•   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.

   With a flexible spending account, you’ll need to sign up through your employer. Similar to an HSA, you would make a pretax contribution, but a FSA covers medical and dependent expenses like childcare.

•   Figure out what tax deductions you can claim when you file your return. As previously noted, when it comes to deductions, Uncle Sam allows you to write off a number of expenses, including real estate taxes, certain casualty or theft losses, and donations made to a charitable organization. People who are self-employed can deduct such costs as office supplies, phone and internet costs, and any travel expenses related to work. These deductions can help save you hundreds or even thousands of dollars on your tax bill.

•   Check that your tax withholding is appropriate. As noted above, check your W-4 form, the one you fill out for your employer to let them know how much tax to take out. It may need to be adjusted if you owe a considerable amount of money in April. On the flip side, if you have too much withheld and get a significant refund, you’re basically giving the government an interest-free loan throughout the year. To be sure you’re paying the right amount, be sure your W-4 form is updated 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, owing more taxes, 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 find and download many of 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 earned income. Report your financial information exactly as it’s reported to the IRS on forms such as your W-2 and 1099.

•   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.

Recommended: 11 Red Flags that Can Trigger a Tax Audit

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 to lower your taxable income, and doing so can result in paying less when the bill comes due or a bigger refund. Knowing how to file correctly and on time can help prevent any delays in reimbursement checks, late fees, or penalties.

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FAQ

Can I lower my income taxes?

Yes, there are several ways you can lower your taxable income. Participating in employer-supported programs (such as pre-tax contributions to a 401(k), FSA, and/or HSA), taking deductions, and choosing the right filing status are all ways you can help reduce your income taxes.

How can I determine how much income tax I’m required to pay?

You can start by estimating your taxable income. This involves taking your adjusted gross income, or AGI. which is the total amount you report that’s subject to income tax; typically, it’s earnings such as wages, dividends, and interest from a bank account, for example. Then you would subtract any tax deductions or eligible adjustments from that amount. What’s left is taxable income. You would then calculate the appropriate tax bracket percentage based on your income and filing status to figure out your tax liability.

Does income tax improve your money management?

It can. Being organized with your taxes can prevent you from owing a large sum come Tax Day, missing the filing deadline, and potentially paying any interest and late filing penalties to the IRS. If you’re self-employed, putting aside taxes from your earnings and paying your taxes quarterly can also help prevent a potentially large tax bill. And, of course, getting a hefty tax refund can go towards savings, investments, or paying down debt.


Photo credit: iStock/Charday Penn

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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