What are Income Taxes?

Earlier this year we shared an overview of what federal taxes are with you. What’s the difference between a federal and income tax? An income tax is simply a tax levied on the income of businesses and individuals. Here in the U.S., our federal government uses the income tax to help run defense, entitlement programs, and other services. According to the Tax Policy Center, individual income taxes are the largest single source of revenue for the United States Government, making up 45% of the revenue in 2008. Some States and jurisdictions also collect income taxes for their own needs.

A Quick History of Income Taxes

We didn’t always collect income taxes at the Federal level here in the U.S. In fact, it wasn’t until 1913, when the 16th Amendment to the Constitution was passed, that we had a permanent income tax. The initial income tax rates were between 1% and 7%, with the majority of tax payers paying under 4%. Since that time, tax rates have risen, but have always maintained a progressive tax rate structure where the more taxable income you have, the bigger percentage of your income you pay in taxes. Our current federal income tax rates stand at: 10%, 15%, 25%, 28%, 33%, and 35%.

Up until 1943 taxes were collected primarily on an annual basis, and were the responsibility of the taxpayer. In 1943 the withholding tax was implemented, placing the burden on employers to withhold income taxes from the employees. Since that time, although income rates and regulations have changed, the overall income tax system has remained relatively the same.

What Counts as Income?

The income tax that you pay is largely derived by multiplying your taxable income by the appropriate tax rates (listed above). The difficult part of the tax code is determining what actually is taxable income. It’s not a simple answer. Thousands of pages of IRS code have been written to try and narrow down the definition. Generally speaking though, for the individual, your taxable income will be your gross (total) income less any deductions and exemptions. Think of these deductions and exemptions as the expenses against your income.

Gross income, the starting point for determining your income taxes, is defined as: “all income from whatever source”. This includes your wages and any tips you receive from your job, interest, dividends, rents, royalty, alimony, pensions, your share of business income, and many, many other things. For a complete list, visit IRS Publication 17: Your Federal Income Tax. If you receive money, odds are, it is considered gross income for tax purposes.

How Are Income Taxes Collected and Reported to the IRS?

As I shared above, most federal and state income taxes are collected by the employer by withholding them from your paycheck. However, this doesn’t account for all of the income you earn during the year, AND, since withholdings are just an estimate of taxes due, any differences in amounts withheld versus owed will need to be reconciled. This is done on an individual basis by completing a Form 1040 each year. Individual income tax returns are due on April 18th, 2011 for income earned in 2010. If you earn income outside of an employer (i.e. self-employed, retirement income), then you need to consider whether quarterly estimated income tax payments should be made to the IRS right now. Find out if your state collects individual income taxes.