When you earn money, you have flexibility over how you use it. You can spend money on necessities or luxuries. You can save money in your bank account or put it to work in the stock market. While people can use money as they desire, everyone should consider income taxes before spending it. The federal government and most states tax a percentage of income. Understanding how income taxes work can help you estimate how much you owe when you file your taxes.
How Does Income Tax Work?
Counties, cities and countries need tax money to cover the costs of public services and other expenses. Income taxes are one way governments collect money to fund these resources. A percentage of earned income is paid in taxes. Each tax filer’s percentage depends on how much they earned for the year and whether they have any deductions.
What Are the Primary Types of Income Tax?
There are three types of income taxes to anticipate when putting money to the side for taxes.
Individual Income Tax
The federal individual income tax follows a progressive tax rate structure with multiple tax brackets. The tax rate gets higher as you earn more income and move higher in the brackets. The more money you make, the more you will pay in taxes. Individual income taxes are more forgiving for people who do not earn as much income.
While the government needs income tax to fund various projects and initiatives, it gives consumers many opportunities to lower their taxes. Tax deductions and credits are available and can make taxes more affordable. A tax deduction reduces your taxable income, which lowers your taxes. Tax credits are more beneficial, as they reduce your final tax bill after accounting for deductions.
Suppose a consumer earns $80,000 per year. A $20,000 tax deduction lowers a consumer’s taxable income from $80,000 to $60,000. Based on results from a tax calculator, that’s a tax savings of almost $6,000. But if you receive a $20,000 tax credit instead, it would cancel out the income taxes owed on an $80,000 income. That’s why the government doesn’t hand out $20,000 tax credits, but you can get tax deductions greater than $20,000. Using deductions and credits together can lead to the most savings.
Business (or Corporate) Income Tax
Business income taxes, also known as corporate income taxes, apply to business entities. The business income tax gives the government extra revenue it can spread across various projects and initiatives. The federal corporate tax rate is currently 21% as a result of the Tax Cuts and Jobs Act of 2017.
State and Local Income Tax
States and counties can charge additional income taxes to fund their initiatives. Every state has taxes because they don’t want to rely exclusively on federal money to cover the costs of public services and vital resources. Some states do not have income taxes but get the money in other ways, such as higher property taxes.
Factors To Consider: What Percent of My Income Is Taxable?
Wondering how much you will owe when you file your taxes? Consider these factors when assessing how much of your income is taxable.
Tax System
The tax system your country uses impacts how much you pay in income taxes. A flat tax system is more straightforward, as everyone gets taxed at the same rate. If the tax rate in a flat tax system is 15%, you can easily perform the calculation. In this scenario, a consumer with $100,000 in taxable income would owe $15,000 when filing taxes.
A progressive tax system is more complex. Your effective tax rate depends on your taxable income and the existing tax brackets. Under a progressive tax system, people who earn less income pay less taxes, while high earners pay a higher effective percentage.
Tax Brackets
Tax brackets are part of a progressive tax system. As you earn more money, you move up to a higher tax bracket. When you reach a higher percentage by climbing up the tax brackets, the money in lower tax brackets does not get taxed at your new rate.
The 2022-2023 U.S. tax bracket established a 10% tax rate on income between $0 to $10,275 and a 12% tax rate on income between $10,276 and $41,775. The U.S. has higher percentages as you move up the ladder, but assume for this example that a consumer reported $40,000 in taxable income.
The first $10,275 gets taxed at the 10% rate, but the remaining cash gets taxed at the 12% rate. The previously addressed $10,275 does not move up to the 12% tax rate even though you pay that rate on some of your income. The federal income tax bill in this scenario comes to $4,595. It is an effective tax rate of 11.49% on a taxable income of $40,000.
Deductions and Credits
Tax deductions and credits lower how much you owe in taxes. While deductions lower your taxable income, credits have a more direct impact and lower your final tax bill. You can compile deductions on your own or use the standard deduction from the IRS. The standard deduction depends on whether a taxpayer files as single or married. Married couples filing jointly get a higher standard tax deduction.
A tax professional can walk you through the applicable deductions and tax credits. Some of the most common tax credits include the earned income tax credit, child care credit, education credit and low-income housing credit.
Income Levels
Earning more income moves you further up the tax brackets and will increase your effective tax rate. A higher income does not increase the amount of taxes you owe in previous tax brackets you passed on the way to your current tax bracket. A higher income can also make you ineligible for certain tax deductions and credits.
Tax Laws and Legislation
Tax laws change often, and the IRS periodically adjusts the tax brackets in response to inflation and other factors. Any of these changes can impact how much you owe in taxes and which deductions and credits you can still use. Staying informed on tax laws and legislation will make it easier to plan your taxes.
Which U.S. States Do Not Have State Income Tax for Individuals?
Some U.S. states do not have income taxes. While no income tax sounds like a good thing, these states still have ways to collect money. You should review how these states tax their residents to determine whether the lack of an income tax outweighs higher taxes in other areas.
- Alaska
- Florida
- Nevada
- South Dakota
- Texas
- Washington
- Wyoming
New Hampshire and Tennessee also do not charge income taxes, but they tax dividends and interest income. These two states are set to exclude dividends and interest income from taxation by 2025.
Anticipating Tax Season
Income taxes allow the government to afford public services and other initiatives. While the taxes are inevitable, coming up with a plan can minimize the impact and leave you more prepared. Allocating funds and putting them in a short-term certificate of deposit can give you a return on funds that will eventually go toward taxes.
Frequently Asked Questions
Who is subject to income tax?
Any resident with taxable income is subject to income tax.
How is income tax calculated?
Income tax is calculated based on how much you earned and your tax bracket.
When is income tax due?
Income tax is due on April 15 of the following year. For instance, taxes on 2023 income are due on April 15, 2024. The IRS sometimes extends the tax deadline.
About Marc Guberti
Marc Guberti is a personal finance writer passionate about helping people learn more about money management, investing and finance. He has more than 10 years of writing experience focused on finance and digital marketing. His work has been published in U.S. News & World Report, USA Today, InvestorPlace and other publications.