What Is Income Tax and How Are Different Types Calculated? (2024)

What Is Income Tax?

Income tax is a type of tax governments impose on the income that businesses and individuals generate. By law, taxpayers must file an income tax return annually to determine their tax obligations.

Income taxes are a source of revenue for governments. They are used to fund public services and pay government obligations. In addition to the federal government, many states and local jurisdictions also levy income taxes.

Certain investments, like housing authority bonds, are exempt from income taxes in some cases.

Key Takeaways

Income tax is a type of tax governments impose on income generated by businesses and individuals within their jurisdiction.
Income tax is used to fund public services, pay government obligations, and provide goods for citizens.
The federal government and many states, as well as local jurisdictions, levy their own income taxes.
Personal income tax is a type of income tax levied on an individual’s wages, salaries, and other types of income.
Business income taxes apply to corporations, partnerships, small businesses, and the self-employed.

What Is Income Tax and How Are Different Types Calculated? (1)

How Income Tax Works

The Internal Revenue Service (IRS) collects taxes and enforces tax laws in the United States. The IRS employs a complex set of rules and regulations regarding reportable and taxable income, deductions, credits, etc. The agency collects taxes on all forms of income, such as wages, salaries, commissions, investments, and business earnings.

History of Income Tax

The United States imposed the nation’s first income tax in 1862 to help finance the Civil War. After the war, the tax was repealed, but it was reinstated after the passage of the Revenue Act of 1913. That same year, Form 1040 was introduced.

Most countries, including the U.S., employ a progressive income tax system in which higher-income earners pay a higher tax rate compared with their lower-income counterparts. The idea behind progressive tax is that those who earn high incomes can afford to pay more tax. For 2023 and 2024, federal income tax rates range from10% to 37%.

Types of Income Tax

Individual Income Tax

Individual income tax is also referred to as personal income tax. This type of income tax is levied on an individual’s wages, salaries, and other types of income. This tax is usually a tax that the state imposes. Because of exemptions, deductions, and credits, most individuals do not pay taxes on all of their income.

The IRS offers a series of income tax deductions and tax credits taxpayers can use to reduce their taxable income. While adeductioncan lower your taxable income and the taxrate used to calculate yourtax, a tax credit reduces your incometaxobligation.

The IRS offers tax deductions for healthcare expenses, investments, and certain education expenses. For example, if a taxpayer earns $100,000 in income and qualifies for $20,000 in deductions, the taxable income reduces to $80,000 ($100,000 - $20,000 = $80,000).

Tax credits help reduce the taxpayer’s tax obligation or amount owed. They were created primarily for middle-income and lower-income households. To illustrate, if an individual owes $20,000 in taxes but qualifies for $4,500 in credits, their tax obligation reduces to $15,500 ($20,000 - $4,500 = $15,500).

Taxable income is youradjusted gross income (AGI)minus any itemized deductions or your standard deduction.

Business Income Tax

Businesses also pay income taxes on their earnings; the IRS taxes income from corporations, partnerships, self-employed contractors, and small businesses.

Depending on the business structure, the corporation, its owners, or shareholders report their business income and then deduct their operating and capital expenses. Generally, the difference between their business income and their operating and capital expenses is considered their taxable business income.

State and Local Income Tax

All but nine U.S. states impose personal income taxes on their residents. The ones that don't are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

Keep in mind, though, that it may not necessarily be cheaper to live in a state that does not levy income taxes. This is because states often make up the lost revenue with other taxes or reduced services.

What's more, other factors determine the affordability of living in a state, including healthcare, cost of living, and job opportunities. For instance, Florida residents pay a 6% sales tax on goods and services, while the state sales tax in Tennessee is 7%.

Note

If you don’t have a complicated tax situation, a tax calculator can give you an idea of how much income tax you might owe.

To further complicate matters, states continually adjust their tax systems in ways both large and small, making it impossible to predict what sort of tax burden their residents will face in the years to come.

What Percent of Income Is Taxed?

The percent of your income that is taxed depends on how much you earn and your filing status. In theory, the more you earn, the more you pay. The federal income tax rate ranges from 10% to 37%.

How Can I Calculate Income Tax?

To calculate income tax, you’ll need to add up all sources of taxable income earned in a tax year. The next step is calculating your adjusted gross income (AGI). Once you have done this, subtract any deductions for which you are eligible from your AGI.

Which States Have No Income Tax?

Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming do not collect state income taxes.

The Bottom Line

All taxpayers pay federal income tax. Depending on where you live, you may have to pay state and local income taxes, too. The U.S. has a progressive income tax system, which means that higher-income earners pay a higher tax rate than those with lower incomes. Most taxpayers do not pay taxes on all of their income, thanks to exemptions and deductions.