An income tax is a tax based on an individual’s or business’s earned and unearned income. It’s levied on salaries, wages, tips, and commissions, as well as interest and dividends.
Learn what income tax is, how to calculate it, and why it matters for you.
Definition and Example of Income Tax
An income tax is a type of tax that is imposed on an individual’s or business’s earned and unearned income.
For example, the United States imposes a federal income tax on its citizens—both those who live in the United States and those who live abroad—as well as on its resident aliens. This income tax generates most of the United States government’s revenue.
How Income Tax Works
Generally, the jurisdiction imposing an income tax has laws in place to instruct taxpayers on how to calculate their income-tax owing. Most states have their own income tax codes that impose state-level income taxes, and some cities and counties impose additional local-level income taxes.
For the United States’ federal income tax system, this set of laws is known as the Internal Revenue Code. It includes rules pertaining to:
- What kind of income is and is not subject to income tax; for example, wages are generally subject to the federal income tax, but interest on state and local government obligations is generally exempt from the federal income tax.
- Deductions and adjustments that taxpayers can take to reduce their income tax liability; for example, individual taxpayers can take either a standard deduction amount for their filing status, age, and blindness status, or they can itemize their deductions against their income.
- The tax rates for each level of income; for example, there are currently seven individual income tax brackets for federal income tax purposes, ranging from 10% for the lowest levels of income to 37% for the highest levels of income.
Let’s say that a taxpayer is single with no dependents, under the age of 65, and not blind. This individual earns $20,000 per year from their job, has no other forms of income, and takes the $12,550 standard deduction for their situation. This standard deduction amount is subtracted from the taxpayer’s wages to calculate their taxable income of $7,450.
The taxpayer would then use the income tax rates for the year to calculate their income-tax owing. In this case, the taxpayer’s taxable income of $7,450 falls entirely within the 10% income tax bracket, so their federal income tax liability is $745, which is $7,450 multiplied by 10%.
If this taxpayer lives or otherwise has a filing requirement in a state that imposes an income tax, they would have to perform similar calculations based on their state’s tax laws.
Do You Need To Pay Income Tax?
Whether you need to pay income tax depends on the rules for the jurisdiction in which you are subject to an income tax. For example, all United States citizens and resident aliens are subject to the income tax rules.
However, you may not have to pay federal income taxes if your standard deduction amount or itemized deduction amount exceeds the amount of money you make. That would reduce your taxable income to $0, which would mean you wouldn’t owe any income tax.
If you had self-employment earnings of $400 or more, you may still be subject to the self-employment tax.
Also, keep in mind that your state—if it has a standard deduction amount at all—may have a lower standard deduction amount than the federal standard deduction amount. That means it’s possible you may owe state income tax but not federal income tax, or vice versa.
Whether or not you need to pay income tax depends on your individual situation and the tax laws imposed by the jurisdictions in which you are subject to the income tax.
How Much Are Income Taxes?
The amount of a taxpayer’s income taxes depend on various factors, such as:
- Amount of income
- Type of income
- Eligibility for any tax deductions or other benefits
- Tax rates in their jurisdictions
- Other income tax rules
Generally, to calculate your income taxes for a particular jurisdiction, you file a tax return in that jurisdiction. A tax return is a standard form or series of forms issued by the taxing jurisdiction that taxpayers complete to calculate their income tax liability, then file with the jurisdiction. For example, individual taxpayers in the U.S. use Form 1040.
Types of Income Tax
Income taxes are categorized in three ways based on the share of taxpayers’ income that goes toward paying them: progressive, regressive, and proportional.
|Income Tax Type||How It Works||Example(s)|
|Progressive||People with higher incomes pay a larger percentage of tax than people with lower incomes.||The federal individual income tax imposes a 10% tax rate on the lowest incomes and a 37% tax rate on the highest incomes.|
|Regressive||People with lower incomes pay a larger percentage of tax than people with higher incomes.||Neither the federal government nor any states impose a regressive income tax. The closest example is the Social Security tax for self-employed individuals, which is imposed on earnings up to a certain amount for the year.|
|Proportional or “Flat”||All taxpayers pay the same income tax rate.||The federal corporate income tax imposes a flat 21% tax rate on all corporate income. The Colorado state income tax imposes a flat 4.55% income tax rate.|
- An income tax is a tax based on a taxpayer’s income after any exemptions, deductions, or adjustments allowed by the tax-imposing jurisdiction’s laws.
- Tax laws vary by jurisdiction, but they generally inform taxpayers of which income is taxable versus non-taxable, any deductions or other benefits, and the income tax rates.
- Whether you need to pay income tax or not depends on your individual situation and the income tax laws where you live or are otherwise required to file a tax return.