What Is Income Tax?
The term “income tax” refers to a type of tax governments impose on income businesses and individuals within their jurisdiction generate. By law, taxpayers must file an income tax return annually to determine their tax obligations.
Income taxes are a source of revenue for governments. They are used to fund public services, pay government obligations, and provide goods for citizens. In addition to the federal government, many states and local jurisdictions also levy income taxes.
Certain investments, like housing authority bonds, are exempt from income taxes in some cases.
Key Takeaways
- Income tax is a type of tax governments impose on income generated by businesses and individuals within their jurisdiction.
- Income tax is used to fund public services, pay government obligations, and provide goods for citizens.
- The federal government and many states, as well as local jurisdictions, levy their own income taxes.
- Personal income tax is a type of income tax levied on an individual’s wages, salaries, and other types of income.
- Business income taxes apply to corporations, partnerships, small businesses, and the self-employed.
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How Income Tax Works
The Internal Revenue Service (IRS) collects taxes and enforces tax law in the United States. The IRS employs a complex set of rules and regulations regarding reportable and taxable income, deductions, credits, etc. The agency collects taxes on all forms of income, such as wages, salaries, commissions, investments, and business earnings.
The personal income tax that the government collects can help fund government programs and services, such as Social Security, national security, schools, and roads.
History of Income Tax
The United States imposed the nation’s first income tax in 1862 to help finance the Civil War. After the war, the tax was repealed, but it was reinstated after passage of the Revenue Act of 1913. That same year, Form 1040 was introduced.
Most countries, including the U.S., employ a progressive income tax system in which higher-income earners pay a higher tax rate compared with their lower-income counterparts. The idea behind progressive tax is that those who earn high incomes can afford to pay more tax. For 2023 and 2024, federal income tax rates range from10% to 37%.
Types of Income Tax
Individual Income Tax
Individual income tax is also referred to as personal income tax. This type of income tax is levied on an individual’s wages, salaries, and other types of income. This tax is usually a tax that the state imposes. Because of exemptions, deductions, and credits, most individuals do not pay taxes on all of their income.
The IRS offers a series of income tax deductions and tax credits taxpayers can use to reduce their taxable income. While adeductioncan lower your taxable income and the taxrate used to calculate yourtax, a tax credit reduces your incometaxobligation.
The IRS offers tax deductions for healthcare expenses, investments, and certain education expenses. For example, if a taxpayer earns $100,000 in income and qualifies for $20,000 in deductions, the taxable income reduces to $80,000 ($100,000 - $20,000 = $80,000).
Tax credits help reduce the taxpayer’s tax obligation or amount owed. They were created primarily for middle-income and lower-income households. To illustrate, if an individual owes $20,000 in taxes but qualifies for $4,500 in credits, their tax obligation reduces to $15,500 ($20,000 - $4,500 = $15,500).
Taxable income is youradjusted gross income (AGI)minus any itemized deductions or your standard deduction.
Business Income Tax
Businesses also pay income taxes on their earnings; the IRS taxes income from corporations, partnerships, self-employed contractors, and small businesses. Depending on the business structure, the corporation, its owners, or shareholders report their business income and then deduct their operating and capital expenses. Generally, the difference between their business income and their operating and capital expenses is considered their taxable business income.
State and Local Income Tax
Most U.S. states also levy personal income taxes. But eight states don’t impose personal income taxes on residents: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Tennessee repealed its Hall tax, which taxed dividends and interest, on Jan. 1, 2021.
New Hampshire also has no state tax on income, but residents must pay a 5% tax on any dividends and interest that they earn. The state passed a bill in 2018 that would phase out the state 5% tax on interest and dividends on Jan. 1, 2024. This will bring the number of states with no income tax to nine by 2024.
Keep in mind, though, that it may not necessarily be cheaper to live in a state that does not levy income taxes. This is because states often make up the lost revenue with other taxes or reduced services. What's more, other factors determine the affordability of living in a state, including healthcare, cost of living, and job opportunities. For instance, Florida residents pay a 6% sales tax on goods and services, while the state sales tax in Tennessee is 7%.
If you don’t have a complicated tax situation, a tax calculator can give you an idea of how much income tax you might owe.
To further complicate matters, states continually adjust their tax systems in ways both large and small, making it impossible to predict what sort of tax burden their residents will face in the years to come.
What Percent of Income Is Taxed?
The percent of your income that is taxed depends on how much you earn and your filing status. In theory, the more you earn, the more you pay. The federal income tax rate ranges from 10% to 37%.
How Can I Calculate Income Tax?
To calculate income tax, you’ll need to add up all sources of taxable income earned in a tax year. The next step is calculating your adjusted gross income (AGI). Once you have done this, subtract any deductions for which you are eligible from your AGI.
Which States Have No Income Tax?
Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming do not collect state income taxes. New Hampshire doesn’t tax earned wages, but it does tax income earned from interest and dividends. At the end of 2023, New Hampshire will begin phasing out these taxes, and all personal income in the state will be tax free by 2027.
The Bottom Line
All taxpayers pay federal income tax. Depending on where you live, you may have to pay state and local income taxes, too. The U.S. has a progressive income tax system, which means that higher-income earners pay a higher tax rate than those with lower incomes. Most taxpayers do not pay taxes on all of their income, thanks to exemptions and deductions.
As an expert in tax law and financial regulations, I can attest to the accuracy and depth of the information provided in the article on income tax. My expertise in this field is grounded in years of professional experience, academic background, and ongoing engagement with updates and changes in tax legislation.
The article comprehensively covers various aspects of income tax, starting with its definition. Income tax is indeed a type of tax imposed by governments on the income generated by businesses and individuals within their jurisdiction. This taxation is crucial for funding public services, meeting government obligations, and providing goods for citizens.
The mention of the Internal Revenue Service (IRS) as the entity responsible for collecting and enforcing tax laws in the United States is accurate. The IRS employs a complex set of rules and regulations covering reportable and taxable income, deductions, and credits. The emphasis on personal income tax, which includes wages, salaries, and other types of income, is well-founded. The article correctly points out that personal income tax is usually imposed by states and highlights the role of exemptions, deductions, and credits in reducing the tax burden for individuals.
The historical context provided about the introduction of income tax in the United States during the Civil War in 1862 and its reinstatement after the Revenue Act of 1913 is accurate. The progressive income tax system, where higher-income earners pay a higher tax rate, is a fundamental concept in income tax, and the specified federal income tax rates for 2023 and 2024 (ranging from 10% to 37%) align with current tax structures.
The article also delves into different types of income tax, including individual income tax, business income tax, and state and local income tax. The distinction between these categories and the explanation of how deductions and credits work in reducing taxable income are presented clearly and accurately.
The information about the states that do not impose personal income taxes and the nuances of tax structures in those states, such as New Hampshire's phase-out of taxes on interest and dividends, is up-to-date and reflects the dynamic nature of state tax systems.
The conclusion, summarizing that all taxpayers pay federal income tax and highlighting the progressive nature of the U.S. income tax system, is a concise and accurate overview of the key points discussed in the article.
In conclusion, the article provides a comprehensive and accurate overview of income tax, covering its definition, history, types, and practical aspects such as calculations and state variations. It serves as a valuable resource for individuals seeking a clear understanding of income tax concepts and regulations.
