What is Federal Income Tax & How Does it Work?

Federal income tax (”income tax”) is the biggest tax the average individual pays in the US. This tax is based on the amount of income you earn each year and is applied on a progressive basis. Generally, this means that the more you earn, the higher your taxes will be.

Whether you work at a grocery store or own a small business, taxes are something we all have to deal with. To help you get a foundational understanding of how income taxes work, we’ll explain the basics of why you pay them, how you’ll be taxed, and how you file.

Key takeaways

• What are income taxes? Taxes paid on taxable income, which includes items such as wages (salary), self-employment earnings, investments, unemployment benefits, and gambling winnings. The majority of income is taxable, unless exempt by law.  
• Why do we pay income taxes? Income taxes help support government initiatives and fund essential services.
• How is income taxed? Income taxes are based on a progressive tax system that applies different tax rates to the portion of your income that falls into corresponding tax brackets.
• How do you file income taxes? You’ll typically use Form 1040 to file your personal income taxes.
• When are income taxes due? Income tax returns must be filed by April 15 unless you get an extension. Income tax payments are due by April 15, even if you may have an extension to file your tax return by a later date.

Why do we pay income tax?

Income tax exists for the same reason many other taxes do: It’s used to fund the federal government. The income taxes you pay contribute to funds that are used to pay for highways, essential programs to support  citizens, the defense budget, and more.

If you’re a first-time filer, you might only be familiar with federal taxes, but your income may also be taxed by your state, city, or county. It’s important to understand your state tax laws and what taxes might apply to you based on where you live so you can properly estimate how much you’ll owe and prepare accordingly.  There are also taxes due on your earned income for Social Security and Medicare.

History of income taxes in the US

While income taxes are an essential part of how we fund government initiatives today, that wasn’t always the case. In fact, income taxes have only existed for a little more than a century in the US. Let’s take a quick look at some of the history of federal income taxes in the US:

• In 1913, the 16th Amendment to the Constitution was ratified, resulting in the first permanent federal income tax for the US.
• Initially, income tax rates were between 1% and 7% and were collected annually.
• Throughout history, the top tax bracket has been raised significantly in response to events such as World War I and World War II. For example, in 1932, in response to the Great Depression, it was raised to 63% for individuals earning over $1 million.
• In 1942, the Revenue Act of 1942 was passed, which resulted in more people qualifying for income taxes.
• In 1943, the withholding tax was introduced under the Current Tax Payment Act to ensure employers withheld income taxes from employees.

 Throughout history, income tax policies have evolved, with  large swings in income tax rates. In recent history, from 2018 to the present day, income tax rates have remained the same, with brackets changing slightly to accommodate inflation and changes in the cost of living.

How does income tax work?

There are several types of income taxes, and income tax rates can change significantly based on how much you make. Let’s take a closer look at the different types of income taxes in the United States and what you need to know as a taxpayer.

What are the types of income tax in the United States?

Personal federal income taxes may be the first thing that comes to mind when you think about income taxes, but there are a few important distinctions you can make.

Personal vs. business income

Most people pay personal income tax, which is based on the income you earn as an employee or self-employed individual. However, if you own a business, you may also have to pay corporate taxes or business income taxes, depending on the tax structure of your business.

Federal vs. State

While the federal government has the highest income tax rates, they’re not the only ones that levy taxes. Many state and local jurisdictions also levy taxes, which means your total income tax rate may vary depending on your location.

It’s important to check your state’s tax authority policies to understand what you may owe. Fortunately for some, there are several states that have no state income taxes for individuals, including:

• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming 

Investments and unemployment

Income tax isn’t just levied on salaries and wages. Anything that’s considered taxable income is subject to income tax, which includes things like capital gains, income from dividend payments, and unemployment benefits.

What’s considered taxable income?

Anything that’s considered taxable income should be reported on your tax return so you can ensure everything is accounted for in your final tax bill. There are a few rules you should know regarding what’s considered taxable vs. nontaxable income.

Earnings

Wages and employee benefits are the most common forms of taxable income, but income from self-employment and side jobs is also taxable. This includes:

• Income from gig work or side jobs
• Renting out personal property
• Selling goods and services online
• Working as an independent contractor
• Noncash compensation (goods or services) provided for services or promotion (such as by influencers and product reviewers)

Some investments

Various types of investments are also subject to income taxes, including:

• Capital gains
• Stock options and stock trades
• Interest and dividends
• Disposing or receiving digital assets and cryptocurrency

Keep in mind that capital losses can be used to offset capital gains, reducing your tax liability.

Other types of income can also be subject to income tax, including certain:

• Prizes and rewards
• Gambling winnings
• Canceled debts
• Court awards and damages
• Royalties and rent received

Certain benefits

You also may be liable to pay income taxes on:

• Social Security income
• Unemployment benefits
• Certain life insurance proceeds
• Retirement plan distributions

If you need help determining whether the earnings, benefits, and money you’ve received qualify as taxable income, a tax professional can help you navigate the requirements.

Calculating your taxable income correctly is necessary to help you determine your adjusted gross income (AGI) and modified adjusted gross income (MAGI).

How much are income taxes?

Your income taxes are calculated based on your filing status and the rates that apply to the tax brackets portions of your income fall into.

Are there any exemptions from income tax?

There are certain exemptions from income tax that you may be eligible for, but you have to meet specific requirements.

Some businesses may be tax-exempt if they’re considered nonprofit organizations. This may includequalifying charitable organizations, churches and religious organizations, private foundations, political organizations, and other organizations deemed to be not for profit may be able to file exempt.

If your standard or itemized deduction exceeds your income or your income is exempt (such as certain Veteran’s disability benefits) or eligible for exclusion (such as some income earned from work abroad) you may not have to pay income taxes.

However, you will likely  still need to file an income tax return to demonstrate that your tax liability is zero. Exceptions to filing may apply if you don’t meet certain filing thresholds.

How are income taxes reported to the IRS?

If you’re an employee, your employer will withhold income taxes from each paycheck and send you a W-2 after  the end of the year. You can use the information from your W-2 to complete your personal tax return.  The amount of money withheld from your paychecks is not typically exactly the same as your total tax liability.  You  may be due a refund (if you overpaid) or owe additional taxes (if not enough was withheld) when you file your tax return.

Self-employed individuals are responsible for paying estimated quarterly taxes since they do not have traditional payroll with tax withholding. Estimated quarterly taxes are due on:

• April 15
• June 15
• September 15
• January 15

If any of these dates falls on a weekend or federal holiday, the due date is the following business day.

Your personal tax return is generally due on April 15, whether you’re self-employed or an employee. Taxpayers who live outside of the United States have until June 15 to file their tax returns, and any individual may request an extension to file to October 15.  When taxpayers have an extended filing deadline (of June 15 or October 15), any taxes owed are still due by the April deadline. You’ll use Form 1040 to calculate your income taxes and file your return. If you need assistance completing your tax return, a tax expert can answer your questions or even do it for you to simplify the process.