What Is Income Tax? Definition & Overview
Whenever you make any form of income up to a certain point, you’ll most likely not be able to keep all of it.
It seems quite unfair that you shouldn’t have full access to your hard earned income – but it’s part of the way that most countries operate. The portion withheld from your income is known as income tax.
Read on as we take a closer look at everything to do with income tax, as well as the different types, how your income is taxed, and how you can calculate how much you owe.
Table of Contents
KEY TAKEAWAYS
- Governments impose on the income produced by individuals and businesses under their control.
- Government duties, public services, and citizen goods are all paid for through income tax revenue.
- Income tax must be paid to the federal government, numerous states, and local governments.
- An individual’s wages, salaries, and other sources of income are subject to the personal income tax.
- Corporations, partnerships, small enterprises, and independent contractors are all subject to business income taxes.
What Is Income Tax?
Income tax refers to a category of tax that governments apply on income produced by organizations and people under their control. Taxpayers are required by law to file an income tax return each year in order to establish their tax liabilities. The fundamental formula for any tax is: tax base X tax rate = tax liability. In the case of income tax, the tax base is taxable income. Taxable income is gross income reduced by certain deductions.
Governments at all levels – federal, state, and local – raise revenues through taxes. These funds are required to pay for various government services, such as education, public roads, social services, police, and defense.
Taxes on some assets, such as bonds issued by housing authorities, are typically waived.
How Does Income Tax Work?
In the United States, federal tax law is enforced and taxes are collected by the Internal Revenue Service (IRS).
Regarding reportable and taxable income, deductions, credits, and other tax-related matters, the IRS has a complicated system of rules and regulations.
State income taxes are imposed and collected by the state government. The purpose is to tax the income of residents and companies conducting business in the state in order to fund state public services.
Local income taxes are usually assessed by cities (for example, New York) and are not limited to local residents.
Taxes are collected by the agency on all types of income, including corporate profits as well as wages, commissions, and salaries.
The government’s income tax revenue is used to pay for services and programs including Social Security, national security, education, and transportation.
Types of Income Tax
There are three types of income tax. They are as follows:
1. Business Income Tax
The IRS taxes the revenue from companies, partnerships, self-employed individuals, and small enterprises. Businesses also have to pay income taxes on their profits.
The corporation, its owners, or shareholders, depending on the type of corporate structure, declare their business income and then subtract their operational and capital expenses. Their taxable business income is typically calculated as the difference between their business income and their operating and capital expenses.
Many states also have a corporate income tax.
2. Individual Income Tax
Personal income tax is another name for individual income tax. An individual’s wages, salaries, and other sources of income are subject to this type of income tax. Both state and federal governments impose this tax. Most people do not pay taxes on all of their income because of exemptions and other deductions.
Taxpayers can use a number of tax deductions provided by the IRS to lower their taxable income. A tax credit lowers your income tax by reducing the amount of tax you owe while a deduction lowers your taxable income and the tax rate used to calculate your tax.
Federal tax deductions are available from the IRS for certain educational costs, investment fees, and medical costs. Tax credits are available to lessen a taxpayer’s tax liability or amount owing. They were largely developed with people in low- and middle-income households in mind.
3. State and Local Income Tax
Most US states impose personal income taxes. However, inhabitants of eight states are exempt from paying personal income taxes: Wyoming, Alaska, Florida, South Dakota, Texas, Tennessee, Washington, and Nevada. On January 1, 2021, Tennessee abolished its Hall tax, which taxed interest and dividends.
Additionally, there is no income tax in New Hampshire. However, all dividends and interest earned by residents are subject to a 5% tax.
The state passed a bill in 2018 that, starting on January 1, 2024, would gradually eliminate the 5% state tax on interest and profits.
Washington state also does not impose a personal income tax. Effective January 1, 2022, the state established an income tax on capital gains, which only applies to the small portion of its wealthiest residents.
By 2024, nine states will have no income tax.
It’s worth noting that residing in a state with no income tax may not always be less expensive. This is because states frequently utilize other types of taxes to generate revenue. Health care, the cost of living, and career prospects are other elements that affect how affordable it is to live in a state.
How Is Income Taxed?
The percentage of your income that is subject to the federal income tax is determined by your filing status and your annual income. Theoretically, your costs increase as your income does. The federal income tax rate is variable, ranging from 10% to 37%. For 2021, federal income tax brackets for single filers are as follows:
- $0 – $9,950: 10% of taxable income.
- $9,951 – $40,525: $995 plus 12% of any sum in excess of $9,950.
- $40,526 – $86,375: $4,664 plus 22 percent on any sum in excess of $40,525.
- $86,376 – $164,925: $14,751 plus 24 percent of the excess of $86,375.
- $164,926 – $209,425: $33,603 plus 32% of the amount over $164,925.
- $209,426 – $523,600: $47,843 plus 35% of the amount over $209,425.
- $523,601 or more: $157,804.25 plus 37% of the amount over $523,600.
How Do You Calculate Income Tax?
You must total up all sources of taxable income earned throughout a tax year in order to determine your income tax liability. Adjusted gross income (AGI) is the total taxable income after deductions and other adjustments, such as student loan interest deduction or self-employed health insurance premiums. Once your AGI is determined, subtract your standard or itemized deductions and a qualified business income deduction (if applicable). The remaining income is your taxable income.
State income taxes are not collected in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Washington state imposed a capital gains income tax effective January 1, 2022. Earned wages are not subject to taxation in New Hampshire, but interest and dividend income are. By the end of 2023, New Hampshire will start gradually eliminating these taxes, and by the end of 2027, there will be no personal income tax in the state.
Summary
The term income tax refers to a category of tax that governments apply on income produced by organizations and people under their control.
Federal income tax is paid by all taxpayers. You can also be required to pay state and local income taxes, depending on where you live. Because of the progressive nature of the U.S. income tax system, individuals with greater incomes are subject to a higher tax rate than those with lower incomes. Thanks to exemptions and deductions, the majority of taxpayers do not have to pay taxes on all of their income.
FAQS on Income Tax
State income taxes are not collected in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming.
You can securely log in to access your federal tax account via the IRS website. Once you’ve logged into your account, you can see your balance and the amount you owe, as well as 18 months’ worth of payment history, access Get Transcript, and see the most important data from your most recent tax return.
No, they are separate. Government and public services, and citizen goods are all paid for through income tax revenue. An individual’s wages, salaries, and other sources of income earned during the year are subject to the personal income tax.
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