Understanding Income Tax Laws

A smiling taxpayer reviews his tax return
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Tax laws can be complicated, and tax software doesn't necessarily make them less so. Fortunately, some fundamental rules and principles can help you understand what taxes are all about and the rules associated with them, from the types of taxes you must pay to being able to exempt certain income from taxation.

Key Takeaways

  • The federal income tax is progressive, meaning your tax rate goes up as your income goes up.
  • Income tax rates range from 10% to 37%, depending on your income.
  • You are expected to pay taxes throughout the year, either through withholding from your paycheck or through estimated tax payments.
  • Both deductions and credits can lower the amount of income tax you owe.

How Do Taxes Work?

The United States has a big budget. Building roads and other infrastructure, funding education, maintaining the military, and paying for other benefits use substantial resources. Taxing individuals and businesses is one of the only ways the country can raise the financial resources to pay for these social and civic needs.

Individuals and businesses pay a percentage of their earnings to federal and state (and sometimes local) governments in the form of income taxes.

Congress and the president of the United States are responsible for writing and approving the country's tax laws. The Internal Revenue Service then enforces these laws, collecting taxes, processing tax returns, issuing tax refunds, and turning the money collected over to the U.S. Treasury, which is responsible for paying government expenses.

Congress and the president are also responsible for establishing a federal budget. The government must raise more money, either through taxation or by selling debt in the forms of bonds and other securities. These types of debt instruments are used every year and increase the federal debt.

People and organizations must report their incomes on tax returns and calculate their taxes due.

Some organizations are exempt from taxation but still have to file returns. Their tax-exempt status could be revoked if the organization were to fail to meet certain criteria. Individuals are exempt from filing tax returns if they earn less than certain limits that are adjusted annually for inflation.

Nonprofit charities are generally exempt from paying federal income tax, sales tax, and property tax. Most do have to pay Social Security and Medicare taxes on behalf of their employees, however. Some must also pay federal unemployment tax.

The amount of tax you owe is based on how much you earn, but it can be affected by many different parts of your financial situation. For example, if you have a pass-through business, 20% of your business income is exempt from taxation. And if you have income from capital gains, it is often taxed at a lower rate than ordinary income. You can reduce your taxes by taking advantage of various tax benefits.

What Are Income Tax Rates?

The federal income tax in the U.S. is progressive. People with higher taxable incomes usually pay a higher percentage of it in taxes than those who make less money.

2022 Tax Rates by Income (Tax Return Filed in 2023)
 Tax Rate Income for Married Filing Jointly Income for All Others
10% $20,550 or less $10,275 or less
12% over $20,550 over $10,275
22%  over $83,550 over $41,775
24% over $178,150 over $89,075
32%  over $340,100 over $170,050
35%  over $431,900 over $215,950
37%  over $647,850 over $539,900

These income ranges are adjusted annually to account for inflation and other changes in the tax code.

Most states follow a progressive tax system for their income tax. Some states have a flat tax rate, meaning they charge the same percentage to everyone, regardless of earnings. A few states have no personal income tax at all.

Other taxes, such as sales tax, are not progressive. Everyone pays the same rate, regardless of their income.

There's some debate over whether a progressive or flat tax rate is better. Politicians who support a flat tax argue that a single tax rate for everyone would greatly simplify the tax. Supporters of a progressive system contend that it is fairer to impose a higher tax rate on taxpayers with higher incomes.

What Types of Income Are Taxable?

Income is divided into two categories: earned and unearned. Earned income is anything generated from working for an employer, yourself, a business, or a farm, including:

  • Wages
  • Business income
  • Pensions and some other retirement benefits
  • Unemployment benefits
  • Sick pay and some fringe benefits
  • Income derived from self-employment
  • Some disability benefits

Unearned income results from interest, dividends, royalties, virtual currencies, and profits from the sale of assets. In other words, you didn't have to "go to work" to earn that money.

Income doesn't include gifts or inheritances, at least not at the federal level.

What Does "Pay as You Go" Mean for Taxes?

The IRS wants you to pay your taxes on an ongoing basis throughout the year. This is commonly referred to as "paying as you go."

If you're an employee, income taxes are taken out of your paychecks in a process called "withholding." Your employer sends that money to the government on your behalf. This ensures that you've paid a certain amount of tax by the end of the year.

If you're self-employed or earn other non-wage income, you aren't subject to withholding on those earnings. You're expected to pay estimated taxes on your income four times per year. You must calculate how much tax will be due on the income you've earned each quarter and send that money to the IRS in advance of filing their tax returns.

As a general rule, you are expected to pay 90% of your tax liability throughout the year in the form of either withholding or estimated taxes. You may be subject to tax penalties if you've underpaid.

Tax Refunds vs. Tax Liability

When you file your tax return, one of three things can happen.

If you paid more tax than you owe, either through withholding or estimated payments, you have overpaid. The IRS will issue you a tax refund. For example, you might complete your tax return and then realize that your total tax liability is $6,000. If you have paid in $6,500 through withholding over the course of the tax year, you'll receive a $500 tax refund from the IRS.

If you paid less tax than you end up owing, you have a tax liability. You will need to send the difference to the IRS when you file your tax return. For example, if your total tax liability is $7,000, but you only paid $6,500, you still owe the IRS $500. This balance must be paid by April 15, or the government will charge you interest and penalties on the amount outstanding.

In some cases, you may find that the tax you paid is exactly equal to the tax you owe. You would not owe money, and you would not get a tax refund.

How Tax Deductions Impact Your Income Tax

You might earn $50,000 for the year, but you won't necessarily have to pay taxes on the full $50,000. The tax code is set up to allow for numerous tax deductions. Deductions are subtracted from your income, so you pay taxes on lower earnings.

For example, money you contribute to a retirement account such as a 401(k) isn't taxable in the year you make the contribution. You won't have to pay any tax on that money until you withdraw it from the retirement plan. Your employer will calculate withholding from your paycheck on a lesser amount after your contributions are subtracted, or you can claim a tax deduction on your return for the amount you contribute.

Money that you contribute to a traditional IRA may be deductible on your taxes, but the IRS limits how much you can contribute each year. The ceiling is $6,000 in 2022 (tax return filed in 2023) and 2021 (tax return filed in 2022). If you are age 50 or older by the end of the year, you can contribute $1,000 more for a total of $7,000.

How Tax Credits Impact Your Income Tax

Tax credits and deductions are two separate things. Deductions subtract from your income, and you're taxed on the balance. Tax credits, on the other hand, reduce the amount that you owe to the IRS.

You might have claimed all of the deductions you qualify for and still owe the IRS $1,000 in taxes. But you won't owe the IRS anything if you also qualify for a $1,000 tax credit. The credit reduces, or can even erase, your tax debt.

Some credits are refundable. You might owe the IRS $1,000 when you complete your tax return, but maybe you're eligible for a refundable tax credit worth $2,000. That credit would wipe out the $1,000 you owe, and the IRS would send you a check for the balance. That's $1,000 in your pocket that you didn't have before.

What Part of Social Security Benefits Are Taxable?

If Social Security benefits are your only income, you likely won't have to pay tax on them. Otherwise, 50% to 80% of your benefits might be taxable, depending on your total income. Social Security benefits are taxed at your ordinary income tax rate.

What Does a Standard Deduction Mean on Taxes?

To claim deductions on your taxes, you can either itemize (claim them one at a time) or take the standard deduction. The standard deduction is a flat amount that you can deduct from your taxable income. It ranges from $12,950 for single filers to $25,900 for married filing jointly or qualifying widow(er) filers in 2022. Additional deductions can be added on if you are over age 65 and/or blind.

The Bottom Line

The goal of tax planning is to choose which tax benefits make the most sense for you. You are free to arrange your financial affairs in such a way as to take advantage of these tax breaks. You can pay less in taxes by managing your finances in a way that minimizes the amount you owe.

Article Sources

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  12. Social Security Administration. "Income Taxes and Your Social Security Benefit."