What Is Income Tax? How It's Calculated and Types

Search Fintrev

Search our guides, reviews and glossary.

Income tax is a tax that a government levies on the income earned by individuals and businesses during a tax year. The amount owed depends on how much taxable income the taxpayer has, the rate schedule that applies to it and any credits that reduce the bill. In the United States, income tax is imposed at the federal level and by most states and some localities. The revenue pays for public services such as national defense, schools and roads.

How Income Tax Works

In the U.S., the Internal Revenue Service (IRS) administers federal income tax. It sets out which income must be reported and which is taxable, and which deductions and credits apply. Reportable income includes wages, salaries, commissions, tips, interest, dividends, business profits and investment gains.

Collection happens during the year as well as at filing time. Employers withhold federal income tax from paychecks based on the information employees provide. People with income that is not subject to withholding, such as freelance earnings or investment income, generally make estimated payments. After the year ends, individuals file a return (Form 1040) that reconciles the tax actually owed with the amount already paid. Overpayment produces a refund, and underpayment leaves a balance due.

Other countries run similar systems through their own agencies. In Canada, for example, the Canada Revenue Agency plays this role.

Calculating Income Tax

The basic income tax formula for an individual works in layers:

1. Gross income: all taxable income received in the year. See gross income for what counts.
2. Minus adjustments (such as certain retirement contributions or student loan interest) = adjusted gross income (AGI).
3. Minus the standard deduction or itemized deductions = taxable income.
4. Apply the tax rate schedule to taxable income = tax before credits.
5. Minus tax credits = total tax liability.
6. Minus withholding and estimated payments = refund or amount owed.

Many eligibility tests for deductions and credits rely on AGI or a variant of it. That variant is explained in modified adjusted gross income.

Worked example (hypothetical)

The figures below are invented to show the mechanics. They are not current IRS brackets or deduction amounts.

Assume a taxpayer has $100,000 of gross income, $5,000 of adjustments and a $15,000 deduction. Assume also a simplified rate schedule: 10% on the first $20,000 of taxable income, 20% on the next $40,000 and 30% on anything above $60,000.

• AGI: $100,000 − $5,000 = $95,000
• Taxable income: $95,000 − $15,000 = $80,000
• Tax on the first $20,000 at 10%: $2,000
• Tax on the next $40,000 at 20%: $8,000
• Tax on the remaining $20,000 at 30%: $6,000
• Tax before credits: $16,000

If the taxpayer qualifies for a $2,000 credit, the liability falls to $14,000. If $15,000 was withheld during the year, the taxpayer gets a $1,000 refund.

Marginal vs. effective rate

The example above shows the most commonly misunderstood point about progressive income taxation. Moving into a higher bracket raises the rate only on the income inside that bracket, not on all income. The taxpayer’s marginal rate is 30%, the rate on the last dollar earned. The effective rate compares total tax with income. Here that is $14,000 ÷ $80,000 = 17.5% of taxable income, or about 14.7% of gross income. A raise that pushes someone into a higher bracket never lowers their after-tax pay because of the bracket change itself.

Deductions vs. credits

A deduction lowers taxable income, so it is worth the deduction multiplied by the taxpayer’s marginal rate. In the example, an extra $1,000 deduction saves $300. A credit is subtracted from the tax itself, so a $1,000 credit saves $1,000. Some credits are refundable, which means they can pay out even when they exceed the tax owed. Many credits were designed mainly for low- and middle-income households.

Types of Income Tax

Individual income tax

Also called personal income tax, this applies to wages, salaries and other personal income. The rate depends on taxable income and filing status (single, married filing jointly, married filing separately, head of household or qualifying surviving spouse). Long-term capital gains and qualified dividends are taxed under a separate, lower rate schedule. Short-term gains are taxed as ordinary income.

Business income tax

Businesses pay tax on profit, meaning revenue minus deductible operating and capital expenses. How that profit is taxed depends on the structure. A C corporation pays federal corporate income tax at a flat 21% (since 2018), and shareholders pay tax again on dividends they receive. Partnerships, S corporations and sole proprietorships are generally pass-through entities: the business itself usually pays no federal income tax, and profits flow to the owners’ personal returns. Self-employed people also owe self-employment tax for Social Security and Medicare on top of income tax.

State and local income tax

Most states tax residents’ income, using either graduated brackets or a single flat rate. Some cities and counties add their own income taxes. Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas and Wyoming impose no personal income tax on wages. Washington taxes the capital gains income of high earners. A state without an income tax is not automatically cheaper to live in. Those states often rely more heavily on sales or property taxes, and housing, healthcare and wages matter too. Florida’s state sales tax is 6% and Tennessee’s is 7%, for example.

A Short History of U.S. Income Tax

The United States first taxed income in 1862 to help finance the Civil War, and that tax was later repealed. A permanent federal income tax arrived after the Sixteenth Amendment was ratified in 1913, which allowed Congress to tax income without dividing the burden among states by population. The Revenue Act of 1913 put the tax into effect, and Form 1040 was introduced a year later.

What Income Tax Is Not

Several other taxes are often mistaken for income tax:

• Payroll taxes (FICA) fund Social Security and Medicare. They are withheld from the same paycheck but are calculated separately, at flat rates, and do not depend on deductions or brackets.
• Consumption taxes such as sales tax, VAT and GST are charged on spending, not earnings.
• Property, estate and gift taxes apply to owning or transferring assets rather than to annual income.

Limitations of Income Tax

Income tax rules are complex. The interaction of deductions, phase-outs, credits and separate rate schedules makes it hard to predict a bill without working through the full formula. A basic tax calculator can give a rough estimate when a situation is simple, but self-employment, investments or multiple states make it less reliable. Taxing corporate profits and then dividends creates double taxation of the same earnings. Because incentives are delivered through deductions and credits, two people with the same gross income can owe very different amounts. Rates, brackets and deduction amounts also change through legislation and annual inflation adjustments, so last year’s figures should not be assumed for the current year. States revise their own systems as well, which makes long-term tax planning by location uncertain.

The Bottom Line

Anyone who earns wages, runs a business or holds investments owes income tax under rules that depend on filing status, business structure and state of residence. Working through the full formula, from gross income to credits and withholding, gives a far better estimate than a quick calculator when finances are complex. Rates, brackets and deductions change through legislation and inflation adjustments, so each year's figures need checking before planning.