Understanding Income Tax: Calculation Methods and Types Explained

What Is Income Tax?

Income tax is integral to government revenue, imposed on income from individuals and businesses alike. Understanding how it's calculated and the types that exist is crucial. With varying systems at federal, state, and local levels, knowing these differences can optimize financial planning. Certain exemptions and deductions offer taxpayers potential savings, impacting what they ultimately owe.

Understanding How Income Taxes Are Collected

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.

Personal income tax helps fund government programs like Social Security, national defense, schools, and roads.

The Evolution of Income Tax in the U.S.

In 1862, the United States imposed its first income tax to help finance the Civil War. The tax was repealed after the war but reinstated with the Revenue Act of 1913. That same year, Form 1040 was introduced.

Most countries, including the U.S., use a progressive income tax system where higher earners pay higher tax rates than lower earners. The idea behind this system is that high earners can afford to pay more in taxes. For 2023 and 2024, federal income tax rates range from 10% to 37%.

Exploring Different 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 a deduction can lower your taxable income and the tax rate used to calculate your tax, a tax credit reduces your income tax obligation.

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).

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. Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming have no state income tax.

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%.

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.

The Bottom Line

All taxpayers are subject to federal income tax, and many also pay state and local taxes, depending on their location. In the U.S., the income tax system is progressive, with higher earners paying higher rates. Taxpayers can lower their taxable income using exemptions, deductions, and credits, resulting in fewer taxes owed on their total income. Understanding how federal and state systems work helps taxpayers manage their obligations and leverage opportunities.