Table of Contents
- What Is Federal Income Tax?
- Key Takeaways
- How Federal Income Tax Works
- Types of Taxable Income
- Gross Income vs. Net Income
- Filing Federal Income Taxes
- Federal Income Tax Brackets
- How Tax Brackets Work
- Marginal Tax Rate vs. Effective Tax Rate
- How to Reduce Your Taxes: Tax Deductions
- How to Reduce Your Taxes: Tax Credits
- State Income Tax vs. Federal Income Tax
- Individual vs. Other Federal Income Taxes
- The Bottom Line
What Is Federal Income Tax?
Let me explain what federal income tax really is. It's a tax imposed by the Internal Revenue Service (IRS) on the yearly earnings of individuals, corporations, trusts, and other legal entities. For you as an individual, this applies to all kinds of income, like wages, salaries, commissions, bonuses, tips, investment returns, and some unearned income.
The system is progressive, so you fall into different tax brackets based on your income level. Higher income means higher tax rates on portions of your earnings. The IRS sets these brackets, rates, and thresholds.
Key Takeaways
You should know that federal income tax is the biggest revenue generator for the U.S. government. It covers costs like building and fixing infrastructure, education, public transport, and disaster aid. Your tax is based on your income and how you file. You can lower it with deductions, such as for mortgage interest, and credits like the Earned Income Tax Credit help specific groups. Remember, the IRS handles federal taxes, while states manage their own if they have them.
How Federal Income Tax Works
When you pay taxes to the federal government or your state and local ones, you're essentially investing in the economy because those funds go toward essential services. This includes building, repairing, and maintaining infrastructure; funding pensions and benefits for government workers; supporting Social Security; covering major health programs like Medicare, Medicaid, CHIP, and marketplace subsidies; aiding safety net programs for lower-income households; funding defense and national security; providing education, health, agriculture, utilities, and public transportation; pursuing initiatives like space exploration; and offering emergency disaster relief.
The federal government's top revenue source is income taxes from residents. Personal income taxes make up about half of that, with corporate taxes being a smaller share. Keep in mind, the government often spends more than it collects, leading to budget deficits.
Types of Taxable Income
There are generally two categories of taxable income: earned and unearned. Earned income comes from employers or self-employment, including wages (salary or hourly), business income, pensions and retirement benefits, unemployment benefits, sick pay, fringe benefits, and self-employment earnings. Unearned income, or passive income, mostly comes from investments, such as interest and dividends, royalties, cryptocurrency trading, and profits from selling assets like stocks.
Gross Income vs. Net Income
You receive your earnings as either gross income or net income, which is your take-home pay. Net income is what's left after deductions for taxes, benefits, and voluntary contributions. When taxes are withheld, your employer pays them to the government for you. The withholding amount depends on your earnings and what you reported on Form W-4. All forms of earnings count as income for tax purposes, including wages, salaries, cash gifts from employers, business income, tips, gambling winnings, bonuses, and unemployment compensation.
Filing Federal Income Taxes
You report and pay federal income taxes using forms from the U.S. Department of Treasury, usually filed electronically. The main form is Form 1040, which lists your yearly income and taxes already paid. There's also Form 1040-SR for those 65 and older. For simple finances, this is all you need, but there are many other forms for special cases like stock market gains or itemized deductions.
Federal Income Tax Brackets
The tax is progressive, so higher earners pay higher rates. I'll detail the brackets for 2024 and 2025 in tables, but understand that they apply differently based on filing status like single, married filing jointly, married filing separately, or head of household.
How Tax Brackets Work
In this progressive system, you pay more as your income increases, benefiting lower earners and collecting more from higher ones. Brackets are ranges with percentages; for example, in 2023, earnings between $44,726 and $95,375 were taxed at 22% for that portion, with lower parts at lower rates and higher at higher rates.
Marginal Tax Rate vs. Effective Tax Rate
Take a single filer earning $80,000 in 2024; they're in the 22% marginal bracket but pay about $12,653 total, making their effective rate around 15.8%. The marginal rate is the tax on each additional dollar, while effective is the overall percentage of income paid in taxes.
How to Reduce Your Taxes: Tax Deductions
To pay less, you can earn less or claim benefits. Deductions reduce your taxable income. For instance, traditional IRA contributions can be deducted, up to $7,000 in 2024 and 2025, saving you taxes based on your bracket. Common ones include the standard deduction ($14,600 single in 2024, $15,000 in 2025) or itemizing for things like charitable gifts, mortgage interest, and medical costs. Other deductions cover retirement contributions or education expenses.
How to Reduce Your Taxes: Tax Credits
Credits directly cut your tax bill dollar-for-dollar, better than deductions. Examples include the Child Tax Credit (up to $2,000), Earned Income Tax Credit for low earners, education credits, and child care credits. Some are refundable, meaning you get money back if they exceed your liability; others are nonrefundable and only reduce to zero.
State Income Tax vs. Federal Income Tax
Besides federal, 41 states and D.C. have income taxes. States without include Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Wyoming, and New Hampshire (phasing out by 2027).
Individual vs. Other Federal Income Taxes
This focuses on individuals, but businesses report income and get credits via forms like 3800. Nonprofits file Form 990 to keep exempt status. Foreign entities with U.S. ties may need to file too.
The Bottom Line
Federal income tax is progressive on all taxable earnings to fund government needs. The IRS updates brackets yearly for different filing statuses.
Other articles for you
A low interest rate environment involves sustained below-average risk-free rates to boost economic growth, benefiting borrowers but disadvantaging savers.
Bank reserves are mandatory cash holdings by banks to ensure stability, prevent runs, and support monetary policy, with requirements set by central banks like the Federal Reserve.
A tax deed transfers property ownership to a government entity due to unpaid taxes, allowing it to be sold at auction to recover the debt.
The statute of frauds requires certain contracts to be in writing to be enforceable and prevent fraud.
Skewness measures the asymmetry in data distributions, indicating whether data is skewed to the left or right.
The 1%/10 net 30 payment term offers a 1% discount for paying an invoice within 10 days, with the full amount due in 30 days otherwise.
An aleatory contract is an agreement dependent on an uncertain event, commonly used in insurance to manage financial risks.
This text is a comprehensive glossary of financial and economic terms starting with the letter 'H' from Investopedia.
The Options Disclosure Document (ODD) is a key guide from the OCC that educates investors on the characteristics and risks of trading standardized options.
Tactical asset allocation is an active strategy that temporarily adjusts portfolio weights to exploit market opportunities before returning to the original mix.