What Is Income Tax and How Are Different Types Calculated?

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What Is Income Tax and How Are Different Types Calculated?

What Is Income Tax?

The phrase “income tax” refers to a sort of tax levied by governments on revenue made by firms and people operating within their borders. Taxpayers are required by law to submit an income tax return each year in order to establish their tax liabilities.

Governments generate money via income taxes. They are used to pay for government commitments, support public services, and give commodities to residents. In addition to the federal government, several states and municipal governments impose income tax payment.

Certain investments, such as housing authority bonds, are usually tax-free.

Key Takeaways

  • Income tax is a sort of tax levied by governments on the earnings of enterprises and persons within their jurisdiction.
  • Income tax is used to support government programs, pay government debts, and give commodities to residents.
  • Income tax is required by the federal government, numerous states, and municipal governments.
  • Personal income tax is a form of income tax applied on wages, salaries, and other sorts of income.
  • Corporations, partnerships, small enterprises, and self-employed individuals are all subject to business income taxes.

History of Income Tax

To help fund the Civil War, the United States enacted the first income tax in 1862. The tax was removed after the war, but it was reintroduced with the passing of the Revenue Act of 1913. Form 1040 was introduced the same year.

Most nations, including the United States, have a progressive income tax system in which higher-income earners pay a greater tax rate than lower-income earners. The concept of progressive taxation is that people with higher salaries may afford to pay more tax. Federal income tax rates will vary from 10% to 37% in 2022.

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How Income Tax Works

In the United States, the Internal Revenue Service (IRS) collects taxes and enforces tax law. The IRS has a complicated collection of laws and regulations concerning reportable and taxable income, deductions, credits, and so on. Wages, salaries, commissions, investments, and company profits are all subject to taxation by the agency.

Personal income taxes collected by the government may be used to pay government programs and services such as Social Security, national security, education, and roads.

Types of Income Tax

Individual Income Tax

Individual income tax is another term for personal income tax. This sort of income tax is collected on wages, salaries, and other forms of income. This tax is often imposed by the state. Most people do not pay taxes on all of their income because of exemptions, deductions, and credits.

The Internal Revenue Service (IRS) provides a number of income tax deductions and tax credits that taxpayers may utilize to decrease their taxable income. While a deduction may decrease your taxable income and the tax rate used to compute your tax, a tax credit lowers your income tax by providing you with a greater refund of your withholding.

The IRS provides tax breaks for medical expenditures, investments, and some educational expenses. For instance, if a person earns $100,000 and is eligible for $20,000 in deductions, his or her taxable income is reduced to $80,000 ($100,000 – $20,000 = $80,000).

Tax credits exist to assist taxpayers lower their tax liability or amount owing. They were designed particularly for middle- and low-income families. For example, if a person owes $20,000 in taxes but is eligible for $4,500 in credits, their tax liability is reduced to $15,500 ($20,000 – $4,500 = $15,500).

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Business Income Tax

Businesses must also pay income taxes on their profits; the IRS taxes corporate, partnership, self-employed contractor, and small company income. The company, its owners, or shareholders declare their business profits and then deduct their operational and capital costs, depending on the business structure. In general, their taxable business income is the difference between their business income and their operating and capital costs.

State and Local Income Tax

Personal income taxes are also levied in the majority of US states. Personal income taxes are not levied in the following states: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Tennessee’s Hall tax, which taxed profits and interest, was removed on January 1, 2021.

New Hampshire has no state income tax, however citizens must pay a 5% tax on profits and interest earned. In 2018, the state enacted legislation that will phase away the state’s 5% tax on interest and dividends on January 1, 2024. By 2024, the number of states with no income tax will have increased to nine.

Keep in mind, though, that living in a state without income taxes may not always be less expensive. This is because governments often compensate for lost income via other levies or decreased services. In addition, additional variables such as healthcare, cost of living, and career possibilities influence the affordability of living in a state. For example, Florida residents pay a 6% sales tax on products and services, but Tennessee residents pay a 7% state sales tax.

If your tax position is not difficult, a tax calculator can estimate how much income tax you may owe.

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What percent of income is taxed?

The percentage of your income that is taxed is determined by your earnings and filing status. Theoretically, the more you make, the more you must pay. The federal income tax rate varies between 10% and 37%.

How can I calculate income tax?

To compute income tax, sum together all sources of taxable income obtained during the tax year. The next step is to compute your adjusted gross income (AGI).After that, remove from your AGI any deductions for which you are entitled.

Which states have no income tax?

State income taxes are not collected in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, or Wyoming. New Hampshire does not tax earned wages, but it does tax interest and dividend income. New Hampshire will begin phasing away these taxes at the end of 2023, and all personal income in the state will be tax-free by 2027.

The Bottom Line

Every taxpayer must pay federal income tax. You may also be required to pay state and local income taxes, depending on where you reside. The United States has a progressive income tax system, which implies that individuals with higher earnings pay a greater tax rate than those with lower incomes. Because of exclusions and deductions, most taxpayers do not pay taxes on all of their income.

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