Federal Income Tax

Because of the varying tax brackets, a taxpayer will usually have an effective tax rate different from their highest tax bracket. The marginal tax rate is the additional tax paid for every extra dollar of income. For example, a 10% marginal tax rate means that $.10 of every next dollar earned will be taken as tax.

However, note that while the marginal rate in the example above is 22%, the effective tax rate is 16.1%. This figure is arrived at by dividing the total tax bill ($12,907) by income ($80,000) and multiplying by 100. The effective tax rate corresponds to what the individual ends up paying in taxes to the government.

How to Reduce Your Taxes: Tax Deductions

There are two ways to pay less tax: make less money or earn more tax benefits. As it’s usually more advantageous to seek out tax benefits, there are several specific places taxpayers can look.

Tax deductions are legislative enactments that allow a taxpayer to reduce the taxable income used to calculate their tax liability. Tax deductions don’t directly reduce the amount of tax a taxpayer must pay.

For example, consider a taxpayer who contributes to a traditional IRA. In many situations, the taxpayer is allowed to deduct their contribution from their taxable income.

Should the taxpayer have contributed the 2024 maximum amount, their taxable income would have been reduced by $7,000. The IRA limits for 2025 remain the same.

If the taxpayer was in the 22% marginal tax bracket, this would have resulted in a $1,540 ($7,000 x 22%) tax savings each year.

Examples of Tax Deductions

The most common federal tax deduction used to reduce your federal income tax liability is the standard deduction. Each taxpayer may claim a standard deduction based on their filing status. This amount (which is reassessed annually) allows a taxpayer to reduce their taxable income by a set amount established by the federal government.

The alternative to a standard deduction is the itemized deduction. This option allows taxpayers to accumulate certain types of eligible expenses and opt to deduct the total allowable amount of these expenses instead of the standard deduction. These types of expenses include charitable contributions, mortgage interest payments, and medical expenses.

Last, there are deductions exclusive of the standard deduction or itemized deduction. For example, as long as taxpayers meet specific contribution and income limit thresholds, certain types of retirement contributions may be deducted. Alternatively, taxpayers may receive deductions on other types of spending such as educational expenses.

How to Reduce Your Taxes: Tax Credits

Certain taxpayers, including parents and low-income earners, are eligible for tax credits that reduce the amount of tax they owe. A tax credit is better than a deduction because it reduces the filer's taxes due dollar for dollar rather than subtracting a percentage of the tax amount owed.

For example, consider a taxpayer who has one child and is therefore eligible for the Child Tax Credit. The taxpayer’s taxable income is $50,000, so the tax liability is $4,500.

The maximum Child Tax Credit for both the 2024 and the 2025 tax years is $2,000, with a cap of $1,700 on the amount that is refundable.

In this example, the credit directly reduces the filer's tax liability from $4,500 to $2,900. The Child Tax Credit is not applied to the $50,000 of taxable income; instead, it is directly applied to the tax liability amount.

The largest tax credits are targeted at specific types of taxpayers. For example, the Earned Income Tax Credit awards tax credits to those with low earned incomes, while the American Opportunity Tax Credit and Lifetime Learning Credit award credits to those pursuing higher education. The Child and Dependent Care Credit benefits those with children/dependents.

Refundable vs. Nonrefundable Tax Credits

Some federal tax credits are nonrefundable, meaning once they reduce your tax liability to $0, the taxpayer will not get a refund due to any unused portion of the credit. An example of a nonrefundable tax credit is the Adoption Tax Credit. Once the credit reduces a taxpayer's tax liability to $0, the taxpayer will owe no tax.

Some credits are refundable. In that case, not only can the tax credits reduce a taxpayer's liability to $0 but the taxpayer may get a check for the unused portion of the credit.

For example, if you owe $750 in taxes but qualify for a $1,000 refundable tax credit, you would pay no taxes and receive the remaining $250 as a refund.

State Income Tax vs. Federal Income Tax

In the U.S., 41 states and the District of Columbia levy state income taxes. These are in addition to federal income taxes.

Not all states have state income taxes. As of 2024, Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, and Wyoming don’t have an income tax. New Hampshire taxes dividends and interest income only, but the state will completely phase out these taxes by 2027.

Individual vs. Other Federal Income Taxes

The information above relates primarily to federal income taxes for individuals. The IRS also collects tax revenue from other entities.

Business Taxes

Businesses must report income and can receive tax benefits similar to individuals. Certain legal business formations, such as partnerships, have different tax filing dates than individual filers.

In addition, businesses can qualify for a wider range of tax credits. Many of these credits derive from the General Business Credit and are figured using Form 3800.

Nonprofits

Charities and nonprofits that have received tax-exempt status must file Form 990 with the IRS to maintain their tax-free status. This is an informational return that does not result in any taxes owed by the nonprofit.

However, information provided on the return may result in further evaluation or revocation of the tax-advantaged status.

Foreign Businesses and Individuals

Individuals or businesses that have income from international sources may be required to file federal taxes.

There are specific rules for foreign entities with income-generating activities within the U.S. and domestic entities with income-generating activities outside the U.S.

The Bottom Line

The federal income tax system in the U.S. is a progressive tax applied to all forms of earnings that make up a taxpayer's taxable income, including earned and unearned income.

Each year, the IRS releases updates to the tax brackets and rates that apply to single filers, married individuals filing separately or jointly, and heads of households.

Correction—March 13, 2025: The 2024 tax brackets have been corrected.