The basics of income tax – an overview

Income tax affects most of us. Nevertheless, there are many uncertainties on the subject: what exactly is it? And how much can an individual be taxed? How do different tax rates work? These questions are important, and wising up on this topic can help you in the long run. This article will introduce the basic concepts of income tax in an easily understandable manner, looking at income tax on a federal, state, and local level. Additionally, not all income is taxable, so it’s good to know where you may be eligible for an exemption or deduction, as a business, or as an individual.

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What exactly is income tax?

Income tax is paid to the federal, state, and local government. If you work in the USA you’ll most likely have to pay a form of income tax, and the amount depends on how much money you make. This is calculated annually – so if you earn $9,000 in one month, but nothing in the other months, you’ll remain in the 10% tax bracket (more on this below). The tax is collected on three levels, federal, state, and local, and its collection reflects how it is used:

  • The tax collected is used by the United States federal government to finance things such as health care, national defense, as well as job and family security. These three are the main areas financed through federal income tax, although areas such as agriculture and international affairs are also financed through federal income tax, albeit minimally.
     
  • State and local taxes pay primarily for things such as education and health care. According to the center on budget and policy priorities, more than half of the state tax revenues fund education and health care. Following this is around 34% on other expenses, which encompasses care for residents with disabilities, pensions, health benefits for public employees, parks and recreation, and so on. The state and local taxes are more likely to have a direct impact on the community you live in, because they are directed straight back into that community.
Definition: Income tax

Income tax taxes each individual on the money they make each year. The taxation rate will depend on the amount of money an individual makes. Income tax can be at a federal, state, or local level, and helps fund public services, health care, and national defense, among other things.

How much can I be taxed?

Income tax is calculated in terms of different tax brackets. Most states use progressive tax rates, which simply means that as you earn more, you pay more back. The different categories of income are the tax brackets, which encompasses a range of incomes. The amount you have to pay is calculated as a percentage, called a marginal tax rate. The following table shows what the tax bracket and marginal tax rates are:

2018 tax rates – single taxpayers

Tax bracket

Marginal tax rate

$0-9,525

10%

$9,525-38,700

12%

$38,700-82,500

22%

$82,500-157,500

24%

$157,500-200,000

32%

$200,000-500,000

35%

Over $500,000

37%

2018 tax rates – married jointly & surviving spouse

Tax bracket

Marginal tax rate

$0-19,050

10%

$19,050-77,400

12%

$77,400-165,000

22%

$165,000-315,000

24%

$315,000-400,000

32%

$400,000-600,000

35%

Over $600,000

37%

Here you can see that for some tax brackets, it is significantly beneficial for some couples to get married to save on the amount they have to pay on income tax.

It may seem drastic for a single person, for example, to have to pay 37% on an income of $500,000, or 12% on an income of $9,625, when they’re only just within that tax bracket – and the good news is that they don’t have to. This is where marginal tax rates come into play. Essentially, what this means is that different income brackets are taxed differently: the first $9,525 is taxed at 10%, regardless if a person earns $8,000 annually or $9,525. The remaining $100 in the case of someone earning $9,625 is then taxed at 12% – and this goes on throughout the tax brackets.

What kinds of income are taxed?

You’ll need to make a tax declaration to the Internal Revenue Service (IRS) stating all the income you have received in that calendar year. An easy way to remember the types of income you can receive (broadly speaking), is to think of money, services, and property. These three things are all ways in which an individual can receive income. This means that wages, salaries, commissions, rental income, alimony, unemployment compensation, and self-employed income are all considered to be a form of income, and are all required to be declared to the IRS as part of your income.

You should also be aware that other forms of income that may not seem as obvious are also taxed. For example, if you receive benefits for services you provide, these may also be considered to be taxable income. For example, if you have a company car which you use for your personal daily life, this may also count as part of your taxable income. These are commonly known as “fringe benefits” and it is worth checking with a tax advisor to see which of these count as part of your taxable income.

Note

You may have to pay tax on income you don’t even have yet. For example, if a relative sends you a check for your birthday, but you don’t cash it by the end of the tax year, the date of the check is what counts, not when you receive the income. So this would also count as taxable income for the year you received it.

Non-taxable income

Income tax doesn’t apply to all types of income, as the name would have you believe. Of course, the majority of a person’s income can be taxed through income tax, but there may be some exceptions to this. For example, inheritance money and gifts are not taxable, as well as child support payments, health care benefits, and welfare payments. The full list can be found on the IRS website under Publication 525, which lists taxable and non-taxable income in detail. If you’re in doubt about what income of yours is taxable, and what isn’t, check with a local tax advisor!

Tax exemptions

Tax exemptions reduce the amount of tax you have to pay, including income tax in the form of personal exemptions, for example.

  • Organizations with tax exempt status: If an organization has applied for and received tax-exempt status from the IRS, then it doesn’t have to pay federal income tax.
     
  • State and local exemptions: State and local governments will often exempt businesses from having to pay certain taxes to stimulate the local economy. This will often apply to sales tax.

Since the beginning of 2018 the following two tax exemptions are no longer required on your federal tax return, but for the two years leading up to the 2018 tax year, you’ll still submit them as part of the return.

  • Personal exemptions: This is a fixed amount, but this fixed amount can increase over the years. Like with a deduction (see below), a personal exemption reduces the gross amount of your income.
     
  • Dependent exemptions: You can also take exemptions for each dependent (e.g. children under 19, students under 24) you claim. If your relative lives with you, they can also qualify as dependents, and your parents will qualify, even if you live separately.

Deductions

Deductions are a fixed amount of money which will not be taxed as part of income tax. They are costs that the government will not tax, so for example, if you are repaying your student loan, you won’t be taxed on the income you made to repay that loan. In other words, the amount paid into student loan repayments each year would be deducted from the gross income, meaning that you’d have to pay less income tax overall.

There is also a deduction known as the “standard deduction,” in which the government won’t tax a certain portion of an individual’s income. This can change from year to year. Furthermore, it is worth checking if your state has state-specific deductions. These may be less general than the standard deduction, and apply only to certain areas. For example, some states will allow you to deduct half of your rent from your gross income – so it is definitely worth checking with your local and state regulations to see if you can find other deductions that apply to you.

Income tax for businesses

Depending on your business’ structure, you’ll either have to file an annual income tax return, or an information return – the IRS has a helpful overview of which structures should file which returns on their business structures page. If you do not pay income tax via withholding, it might be the case that you have to pay estimated tax. This means that you must still pay tax on your income, but you estimate the tax you have to pay on your regular payments. Estimated tax isn’t just used to pay just income tax, however, but also other taxes such as self-employment taxes, if applicable. More information can be found on the IRS website’s estimated tax page, and it may be helpful to consult a tax advisor.

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