Think of government as an engine and taxes as fuel. If you don’t fuel an engine, it won’t run, and if you don’t pay taxes, government can’t do the important things it does. Income taxes are the federal government’s primary source of fuel, enabling it to fund the military, build roads, protect the environment, regulate commerce and perform a vast list of other important duties.
What Is Income Tax?
As the name suggests, income taxes are levied on many forms of earnings. Workers pay tax on their wages. Investors are taxed on money they earn from stocks, bonds, bank accounts, rental properties and other investments. Companies pay taxes on their profits.
Individuals alone are expected to pay nearly $1.7 trillion in federal income taxes in 2020, nearly half the federal government’s revenue. All but seven states – Alaska, Florida, South Dakota, Nevada, Texas, Washington and Wyoming — also impose a state income tax, which makes up a substantial amount of state government revenue. Even cities have their own income taxes, which most impose on money people earn in their jurisdictions.
Income tax is voluntarily reported once a year, but the federal and state governments maintain complicated codes for what is taxable and what is exempt. Employers typically withhold tax money during the year from their workers’ paychecks and report earnings to the tax collection agencies soon after a tax year ends on W-2 forms. Other income payments are reported on forms called 1099s. The various income reports allow tax collectors to know how much people earned. Most income taxes are progressive, meaning the amount a taxpayer contributes increases with the amount he or she earns.
Failure to pay the voluntary income tax is illegal and can result in penalties and possible criminal charges.
A Brief History of Income Taxes
Benjamin Franklin once said that nothing in this world is certain except death and taxes – and he was right.
In its earliest days, the U.S. government was supported by excise taxes on certain products and commodities and then by tariffs on imported goods. In 1862, President Abraham Lincoln created the Bureau of Internal Revenue to collect monies to pay for the Civil War, and the first income tax was levied. Over the next 50 years, the income tax was either supplemented or replaced by various sales, excise and other taxes.
The 16th Amendment, ratified in 1913, gave Congress the authority to levy income tax on both individuals and corporations. In that year, Congress enacted its first income tax law and issued the first 1040 tax form. A 1% tax was levied on net personal incomes above $3,000, with a 6% surcharge on incomes above $500,000.
Today the Internal Revenue Service (IRS), a bureau of the U.S. Treasury Department, collects federal income taxes and enforces the Internal Revenue Code. It collects more than $2.4 trillion from approximately 234 million individual and business tax returns a year.
Most American citizens are expected to file federal tax returns by April 15 each year. Self-employed individuals and businesses must file quarterly returns.
The process of filing a return can be as easy or complicated as your personal financial situation. The more ways you make money, the more ways you save for retirement, the more investments you have and the more you take advantage of tax credits and deductions, the more complex your tax return is likely to be.
Calculating Taxable Income
Federal tax rates are charged in brackets ranging from 10% of income to 37%. But the tax code contains many provisions that allow earners to adjust their income. They can deduct certain expenses from their gross income, affecting their tax bracket. Taxes are graduated, so in 2018 a single taxpayer pays 10% on the first $9,525 of income, then 12% on income from $9,526 to $38,700 and so on until reaching the highest bracket, 37% on income of more than $500,000.
Filing status further complicates the equations. Taxpayers can file as single, married filing jointly, married filing separately or as head of a household. Each filing status has its own brackets, which are set by Congress.
Higher income earners have long sought help from tax professionals in preparing tax returns. The reason: Income levels can be adjusted through deductions and write offs. Deductions are complex and usually require filers to complete worksheets, called schedules, to calculate how much of their income is taxable.
In 2017, Congress passed a tax code overhaul aimed at simplifying tax preparation. It greatly raised the standard deduction – a fixed amount that people can subtract from their gross incomes – for 2018 taxes as long as they didn’t use the supplemental tax schedules to itemize deductions. The new approach should mean far fewer people itemizing deductions during the 2019 tax filing season.
Though a minority of taxpayers itemized deductions in the past, far fewer were expected to continue doing so under tax rules introduced in the 2018. Congress nearly doubled the standard deduction from $6,350 in 2017 for single filers and married taxpayers filing separately to $12,000; from $9,350 to $18,000 for heads of household files; and $12,700 to $24,000 for married taxpayers filing jointly.
That change is significant because taxpayers can either itemize or take the standard deduction, but they can’t do both. Since the standard deduction for many filers will exceed the tax savings that itemizing might produce, fewer will itemize.
Deductions have changed, some in drastic fashion. Here is a summary of the changes made for property and home mortgages:
- A big one for taxpayers living in areas with high local and state taxes was a deduction for property taxes. Under the new code, the deductions are capped at $10,000, so if you paid more than $10,000 in real estate taxes, you couldn’t deduct all your taxes.
- Interest paid on home equity lines of credit is moving from deductible to not deductible in 2018, though interest paid on a mortgage to buy or improve a home is deductible on loans of up to $750,000, a decrease.
- Interest on mortgages taken out before Dec. 15, 2017 continue be deductible on loans as large as $1 million.
Other deductions are unchanged. For instance, you can still deduct up to $2,500 in interest paid on student loans. The provisions remain dense, and it is worth estimating how many deductions you might have before deciding to itemize rather than using the standard deduction,
Other Changes to the Tax Code
The 2017 tax reform act, officially called the Tax Cuts and Jobs Act, paired with updates from the Internal Revenue Service, yielded substantial changes for taxpayers. The increase in the standard deduction and the elimination of personal exemptions were among the biggest changes. Though a call from some conservatives in Congress to reduce the tax return to a postcard never happened, it’s likely that many people will spend less time worrying about itemizing deductions as they opt for the increased standard deduction.
The tax reform was widely received as a benefit for wealthier filers, and in many ways it was. It lowered the top tax rate by 2 percentage points and doubled the size of estate subject to inheritance taxes. But it has advantages for the less well-heeled too. The child tax credit to dependent children younger than 17 doubled to $2,000. Tax credits, unlike deductions, come straight off the tax bill and it is a credit for each child who meets the criteria. Credits for other dependents are limited to $500.
Another change that mostly impacts taxpayers from high taxation states is a $10,000 on the amount of state and local taxes that can be deducted on the federal tax return. Also, in tax year 2018 most miscellaneous itemized deductions like unreimbursed employee expenses and investment fees are going away. Under the old tax law, you could claim miscellaneous itemized deductions if they exceeded 2% of adjusted gross income.
Filing Procedures and Deadlines for Federal Income Taxes
As April 15 approaches, taxpayers can choose how to file their returns. The oldest, and least efficient method, is by mail. Forms and instructions can be obtained online at the IRS website, at a local IRS office or at public places like a library or post office. After the forms are filled out properly, they can be mailed to the appropriate IRS address listed on the agency’s website or on the instruction booklet that accompanies the form.
However, fewer and fewer people mail their returns each year. In 2018, 92% of taxpayers – more than 126 million people – filed their returns electronically. Electronic filing can be done from any computer or from the office of any authorized e-file provider, who can also help with the preparation of the return. While the IRS doesn’t require electronic filing, it recommends it. E-filing generally assures a quicker refund than filing by mail.
Individuals who have trouble meeting a filing deadline can apply for an extension. Both electronic and paper options to file an extension are available. Taxpayers who miss filing deadlines can incur severe penalties, including interest charges and late fees.
Individual income taxes are generally paid in three ways, each with its own deadline:
- Withholding taxes: Money that is taken out of a person’s paycheck each pay period that must be paid to the government by an employer, on a quarterly basis.
- Estimated tax payments: Money that must be paid quarterly, generally by self-employed individuals whose taxes are not withheld by an employer.
- Income tax return: Money that must be paid by an individual by Tax Day (normally April 15) of each year, on income from the preceding year, along with the filing of all individual income tax return forms.
Taxpayers must indicate their filing status on their tax returns.
There are five different statuses that determine the amount of taxes owed, and which deductions and credits are applicable:
- Single – a taxpayer who is unmarried or legally separated
- Married Filing Jointly – all income, exemptions and deductions must be included for both spouses
- Married Filing Separately – each spouse files a return, but they must both claim the standard deduction, or both itemize deductions (this status has the highest tax rate)
- Head of Household – the filer must be unmarried or living apart from a spouse for the last six months of the tax year; have paid more than half the cost of keeping up a home; and have a qualified person living in the home for more than half of the year
- Qualifying Widow(er) with Dependent Child – the filer must: have been eligible to file a joint return with a spouse the year he/she died; can’t have remarried; be able to claim a child as an exemption; and paid more than half the cost of keeping up the home in which the child resides
Who Must File
In addition to one’s filing status, an individual’s age and income will determine if he or she must file a federal income tax return. Individuals older than 65 have higher income thresholds than younger taxpayers. Individuals whose gross income is below the threshold may not have to file a return. The amounts in the table are for filers with W-2 income from a job that pays wages.
|Filing Status||Age on Dec. 31, 2017||File return if gross Income was at least …|
65 or older
|Married Filing Jointly||Under 65 (both)|
65 or older (both)
65 or older (one)
|Married Filing Separately||Any Age||$4,050|
|Head of Household||Under 65|
65 or older
|Qualifying Widow(er)||Under 65|
65 or older
If a taxpayer’s gross income falls below the applicable level, there are still reasons that may require the filing of a return, including:
- Having a net self-employment income of more than $400
- Earning more than $108.28 from a tax-exempt church organization, among other reasons.
- Owing the alternative minimum tax
- Owe household employment taxes
- Owing additional taxes on a retirement plan such as an IRA or on a health savings account
- Required to repay the 2008 Homebuyer Credit
- Owe Social Security and Medicare taxes on tip income
- Received distributions from a Health Savings Account
- Received advanced payment on the Premium Tax Credit
In addition, an individual may want to file a return:
- If taxes withheld from pay would result in a refund.
- To claim a tax credit like the Earned Income Tax Credit (EITC) for low-income families or the American Opportunity Tax Credit for reimbursement of qualified education expenses
- To claim any tax overpayments that have been made
- If you overpaid estimated taxes or applied a previous year’s overpayment to the current year, you need to file to receive a refund
- To receive the adoption tax credit for a qualified adopted child
- To claim a refund from the Health Coverage Tax Credit
Tax Brackets and Rates
The federal income tax is progressive: the higher your income, the greater percentage of that income must be paid in taxes. Because of the Tax Cuts and Jobs Act of 2017, there are seven graduated tax brackets with rates ranging from a low of 10 percent to a high of 37 percent.
Each bracket comprises a range of “taxable income” – the amount of income from all sources minus all of the adjustments, exemptions and deductions that an individual taxpayer is allowed to take. For each bracket, the tax burden is different.
- Single, earns less than $9,525 is in the 10% bracket
- Single, earns between $9,526 and $38,700 owes $953 plus 12% of amount over $9,525
- Single, earns between $38,701-$82,500 owes $4,454 plus 22% of amount over $38,700
- Single, earns between $82,501-$157,500 owes $14,090 plus 24% of amount over $82,500
- Single, earns between $157,501-$200,000 owes $32,090 plus 32% of amount over $157,500
- Single, earns between $200,001-$500,000 owes $45,690 plus 35% of amount over $200,000
- Single, earns over $500,001 owes $150,690 plus 37% of amount over $500,000
For the purposes of deductions, a taxpayer’s marginal rate is the bracket that contains the highest portion of taxable income. The actual rate paid, called the effective rate, always will be lower since the first portions of taxable income get taxed at the lower rates.
All living individual filers now use the 1040 tax form and most can file their taxes electronically. Only first-time filers are required to file a paper return.
Preparing a tax return is often made easier with the use of free or low-cost tax software. First-time filers can also visit a tax preparer to make sure that they have filled out the form(s) correctly. In addition, all filers can request help from the IRS either over the phone or in person at an IRS office.
Filing State and City Income Tax Returns
Forty-three states, and some cities, counties and other governmental units also impose taxes on various types of income, i.e. wages, interest and/or dividends. The 43 states that impose an income tax on wages require their employers to withhold income taxes from their workers, just as they withhold federal income taxes.
Some taxing authorities impose flat rates, while others have graduated rates, similar to the federal brackets, only much lower. It is up to the individual to determine which sources of income are reportable to a state or local government, how taxes are calculated, and where forms are to be sent. Information can usually be accessed by visiting a jurisdiction’s website or contacting the appropriate government office.
Generally, income taxes paid to states and localities offset the taxes due to the federal government. And like the federal government, states impose penalties for failing to file required tax returns and/or pay any owed taxes on a timely basis.
Taxes and Debt
Nobody likes paying taxes. But failure to pay them can result in fines and penalties, liens against property, and even prison. That is why it is important to make sure that your tax bill doesn’t force you into debt, or worse, deeper into debt.
If you are an employee, subject to withholding tax, make sure that your employer withholds the appropriate amount of income from each paycheck, so that when April 15comes around, you’re not hit with an unmanageable tax bill. You can do this by determining the correct sum on the W-4 form that you filled out when you first were hired. Increasing the amount of withheld taxes may shrink your paycheck somewhat, but it will keep you on par with what you ultimately will owe the government. Most taxpayers have more taxes withheld than they actually wind up owing, and receive a refund every year.
If you are self-employed, you need to make estimated tax payments quarterly. That means that you have to determine your likely income for the year and pay taxes every three months. The IRS will allow a certain discrepancy between what you’ve paid and what your final tax bill will be, but if you have underpaid by too much, you might incur a penalty.