Federal Income Tax

What Is Federal Income Tax?

The U.S. federal income tax is levied by the Internal Revenue Service (IRS) on the annual earnings of individuals, corporations, trusts, and other legal entities. Federal income taxes apply to all forms of earnings that make up a taxpayer's taxable income, including wages, salaries, commissions, bonuses, tips, investment income, and certain types of unearned income.

In the U.S., federal income tax rates for individuals are progressive, meaning that as taxable income increases, so does the tax rate. Federal income tax rates range from 10% to 37% and kick in at specific income thresholds. The income ranges to which the rates apply are called tax brackets. Income that falls within each bracket is taxed at the corresponding rate.

How Federal Income Tax Works

Tax is collected from individuals and corporations by the city, state, or country where they reside or operate. When the tax collected is credited to the country's government, it is referred to as a federal tax.

Governments use the money collected through federal taxes to pay for the growth and upkeep of the country. Some look at federal tax as “rent” charged to live in a country or the fee to use the resources provided by a country. When you pay tax to the U.S. government, you’re investing in your economy, as the government uses the funds to do the following:

• Build, repair, and maintain infrastructure
• Fund the pensions and benefits of government workers
• Fund Social Security programs
• Fund major health programs, including Medicare, Medicaid, CHIP, and marketplace subsidies
• Fund "safety net" programs to assist lower-income households
• Fund defense and international security programs
• Improve sectors such as education, health, agriculture, utilities, and public transportation
• Embark on new feats such as space exploration
• Provide emergency disaster relief

The largest source of revenue for the federal government comes from the income of its residents. In 2021 (the latest data available), the IRS collected nearly $4.1 trillion in receipts, of which individuals, estates, and trusts contributed $2.3 trillion. Meanwhile, business income taxes accounted for about $419 billion.

Types of Taxable Income

Many different types of income are taxable. In addition, different forms of income may be assessed at different tax rates. Generally speaking, there are two types of income: earned income and unearned income. 

Earned income is income primarily generated by being employed by an employer, including if you are self-employed. The most common forms of earned income are:

• Wages, whether by salary or hourly pay
• Business income or income from operations
• Pensions and other forms of retirement benefits
• Unemployment benefits
• Sick pay and other forms of fringe benefits
• Self-employment income

Unearned income is income primarily generated by more passive forms of activity, especially surrounding investing. The most common forms of unearned income are:

• Interest income or dividends
• Royalties or residual income
• Staking rewards or airdropped cryptocurrency
• Sales of assets at a profit
  

Gross Income vs. Net Income

Workers receive their earnings either as net income (NI), also known as take-home pay, or gross income. Net income is the total amount received after taxes, benefits, and voluntary contributions are deducted from the paycheck. When taxes are withheld, it means the company or payer has paid the tax to the government on the worker’s behalf.

The amount your employer withholds for taxes depends on how much you earn and the information you gave your employer on Form W-4. All money earned, whether as a wage, salary, cash gift from an employer, business income, tips, gambling income, bonuses, or unemployment compensation, constitutes income for federal tax purposes.

Filing Federal Income Taxes

Federal income taxes are reported and remitted to the IRS through a series of forms created by the U.S. Department of Treasury. The primary form used to report Federal income taxes is Form 1040 which collects not only your personal information but your income and tax benefit activities for the year.

There are several variations of Form 1040 based on the type of activity incurred by the taxpayer over the prior year; an example of the first page for Form 1040-SR is below.

If a taxpayer has more information to submit to the IRS, they usually attach or provide additional forms. For example, if you decide to claim an itemized deduction (discussed below), you are required to submit Schedule A to support your return. Many tax credits (also discussed below) require additional forms.

Federal Income Tax Brackets

The federal income tax is built on a progressive tax system, where higher-income earners are taxed at higher rates. The tables below show the tax brackets and rates for 2022 and 2023.

How Tax Brackets Work

The United States uses a progressive tax system, meaning taxpayers pay more incremental tax as they earn more income. This system aims to provide inherent tax benefits to lower-income individuals and collect more taxes from higher-income individuals.

Tax brackets are often cited as a range of income with an associated percentage. For example, for 2023 federal income taxes, taxpayers that earn between $44,726 and $95,375 are “in the 22% tax bracket”. This means their earnings between these two amounts are assessed a 22% tax rate. Earnings below $44,726 are assessed a lower rate, and earnings above $95,375 are assessed a higher rate. 

Marginal Tax Rate vs. Effective Tax Rate

As an example, an individual who is single and earns $80,000 annually falls into the 22% marginal tax bracket. This means the taxpayer would be responsible for $12,908 in taxes for 2023, the breakdown for which is illustrated in the chart below:

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 is 22%, the effective tax rate is 16.1%. This figure is arrived at by dividing the total tax bill ($12,908) by income ($80,000) and multiplying by 100. The effective tax rate is the actual rate 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 amount of income they are taxed on their return. Though tax deductions don’t directly reduce the amount of tax a taxpayer must pay, it does reduce the calculation basis for the taxpayer’s tax liability.

For example, consider a taxpayer that 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 2023 maximum amount, their taxable income would be reduced by $6,500. If the taxpayer is in the 22% marginal tax bracket, this would result in a potential $1,430 ($6,500 * 22%) tax savings.

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

Tax credits are legislative enactments that allow a taxpayer to reduce the amount of tax they owe. After a taxpayer’s tax liability is calculated, a taxpayer may then directly reduce their liability by tax credit amounts they are eligible for. 

Take a taxpayer who has one child and is eligible for the Child Tax Credit. The taxpayer’s taxable income is $50,000, and the taxpayer’s tax liability is $4,500. The Child Tax Credit directly reduces the 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 all associated with legislative incentive endeavors for specific types of taxpayers. For example, the Earned Income Tax Credit awards tax credits to those of low income, while the American Opportunity Tax Credit and Lifetime Learning Credit award those pursuing higher education. The Child and Dependent Care Credit benefit those with children/dependents.

Refundable vs. Nonrefundable Tax Credits

Some Federal tax credits are nonrefundable, meaning once they reduce your tax liability to $0, a taxpayer may not receive additional benefit nor receive a refund due to an 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 simply not pay tax.

On the other hand, other credits may be refundable; not only can refundable tax credits reduce a taxpayer's liability to $0, they may flip the taxpayer into receiving a tax refund. For example, if you owe $750 in taxes but qualify for a $1,000 refundable tax credit, you would ultimately receive a $250 tax refund.

Be mindful that some credits are partially refundable. For example, the Child Tax Credit of $2,000 is partially refundable; in 2023, up to $1,600 is refundable.

State Income Tax vs. Federal Income Tax

It is important to distinguish between the definition of income tax and federal income tax. In the U.S., governments at the state level may also levy income taxes in addition to federal income taxes.

Not all states have state-level income taxes. Currently, Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, 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 has been primarily informative regarding individual Federal income taxes. The IRS also collects tax revenue from other entities.

Businesses must report income and receive tax benefits similar to individuals. Certain legal business forms, such as partnerships, have a different tax filing date compared to individual filers. In addition, businesses are subject to a wide range of tax credits only available to businesses; many credits derive from the General Business Credit filed using Form 3800.

Charities and nonprofits that have received tax-exempt status must also usually file a Form 990 with the IRS to maintain their tax-free status. This information return does not result in any taxes owed from the nonprofit. However, information provided on the return may result in further evaluation or revocation of the tax-advantaged status.

Last, international individuals or businesses may be required to file Federal taxes within the U.S. There are specific rules for foreign entities with income-generating activities within the United States and domestic entities with income-generating activities outside the United States.

The Bottom Line

Federal income taxes are considered a marginal tax or progressive tax and apply to all forms of earnings that make up a taxpayer's taxable income, including wages, salaries, commissions, bonuses, tips, investment income, and certain types of unearned income. Each year, the IRS releases updates to the tax brackets and rates that apply to single filers, married individuals filing joint returns or separately, and heads of households.