How the Taxation of Individuals Works in the U.S.

The U.S. federal income tax system is progressive, meaning higher portions of income are taxed at greater rates. The system operates on a pay-as-you-go basis, where individuals pay tax on income as it is earned. This annual process involves calculating total income, subtracting deductions to find taxable income, and then computing the tax. Tax credits and payments are then applied to determine if a refund is due or a balance is owed.

Determining Filing Requirements and Status

A taxpayer must first determine if they are required to file a federal income tax return based on gross income, filing status, and age. Gross income includes all income received that is not tax-exempt. For the 2024 tax year, a single individual under 65 must file if their gross income is at least $14,600. For married couples filing jointly under 65, the threshold is $29,200. Special rules also apply to dependents who may have their own filing requirement.

Selecting the correct filing status affects the standard deduction, tax rates, and eligibility for certain credits. The five filing statuses are:

• Single: For unmarried individuals.
• Married Filing Jointly: For married couples who combine their incomes on one return.
• Married Filing Separately: For married couples who report tax liabilities on separate returns.
• Head of Household: For unmarried individuals who pay more than half the cost of maintaining a home for a qualifying person.
• Qualifying Surviving Spouse: Allows a widow or widower with a dependent child to use joint return tax rates for two years after their spouse’s death.

A dependent must be either a “Qualifying Child” or a “Qualifying Relative.” To be a Qualifying Child, an individual must meet tests related to their relationship to the taxpayer, age, residency, and the amount of financial support they provide for themselves. A Qualifying Relative can be a broader range of family members or an unrelated person who lived with the taxpayer, but they must receive more than half of their support from the taxpayer and have limited gross income.

Calculating Total Income

The foundation of any tax calculation is determining total income, which is the sum of all income from any source before any deductions are taken. The IRS requires taxpayers to report income from a wide variety of sources.

Earned Income

This category includes compensation for personal services, such as wages, salaries, and tips. This information is reported to employees on Form W-2, which details total wages and the amount of federal, state, and payroll taxes withheld. All taxable employee pay, including vacation and sick pay, must be included.

Self-Employment Income

This applies to freelancers, independent contractors, and business owners. Payers report nonemployee compensation on Form 1099-NEC, but all self-employment income must be reported regardless. Gross receipts are reduced by ordinary and necessary business expenses, and the resulting net profit is included in total income.

Investment Income

Income from investments must be included in total income. This includes interest earned from bank accounts or bonds, which is taxed at ordinary income rates. Dividends received from stocks are also investment income, with qualified dividends being taxed at lower long-term capital gains rates. Capital gains arise from selling assets like stocks or real estate for a profit, with tax rates depending on whether the gain is short-term (held one year or less) or long-term (held more than one year).

Retirement Income

Distributions from retirement plans constitute taxable income for many retirees. This includes payments from pensions, annuities, 401(k)s, and traditional Individual Retirement Arrangements (IRAs). Withdrawals from traditional, tax-deferred accounts are taxed as ordinary income. Withdrawals from Roth IRAs and Roth 401(k)s are tax-free, as contributions are made with after-tax money.

Other Common Income

Several other sources of income must be accounted for. Unemployment compensation is fully taxable and must be reported. Up to 85% of Social Security benefits can be taxable if a recipient’s total income exceeds certain thresholds. Alimony payments from divorce or separation agreements executed after December 31, 2018, are not taxable to the recipient.

Arriving at Taxable Income

After calculating total income, the next step is to determine taxable income. This begins with calculating Adjusted Gross Income (AGI) by subtracting specific “above-the-line” deductions from total income. These deductions are available regardless of whether a taxpayer itemizes. Reducing AGI is beneficial because it can increase eligibility for other tax benefits that are phased out at higher income levels.

Common above-the-line deductions include:

• Contributions to a traditional IRA
• The student loan interest deduction
• Contributions to a Health Savings Account (HSA)
• One-half of self-employment taxes
• Educator expenses
• Certain self-employed health insurance premiums

Once AGI is established, the taxpayer chooses between the standard deduction or itemizing. The standard deduction is a fixed dollar amount that varies by filing status. For 2024, the standard deduction for a single individual is $14,600, and for married couples filing jointly it is $29,200. Most taxpayers use the standard deduction for its simplicity.

A taxpayer should only itemize if their total eligible expenses exceed their standard deduction. Itemized deductions are reported on Schedule A. One category is for medical and dental expenses, but these are only deductible to the extent they exceed 7.5% of the taxpayer’s AGI.

Another itemized deduction is for state and local taxes (SALT), including income, sales, and property taxes, but the total SALT deduction is capped at $10,000 per household. Home mortgage interest is also an itemized deduction, limited to interest on up to $750,000 of mortgage debt. Finally, charitable contributions to qualified organizations can be deducted, with cash contributions typically limited to 60% of AGI. After subtracting either the standard or itemized deductions from AGI, the result is taxable income.

Computing Tax and Applying Credits

The United States uses a progressive tax system with tax brackets, meaning higher portions of income are taxed at higher rates. For 2025, the seven tax rates for ordinary income are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The system works on a marginal basis. For a single filer with $50,000 in taxable income, the first portion of income is taxed at 10%, the next portion at 12%, and only the final portion at 22%. The total tax is the sum of the calculations from each bracket.

After the initial tax is calculated, tax credits are applied. A tax credit provides a dollar-for-dollar reduction of the tax liability itself, making it more impactful than a deduction, which only reduces taxable income.

A nonrefundable credit can reduce tax liability to zero, but no excess amount is paid as a refund. Refundable credits, however, are paid out to the taxpayer even if they have no tax liability. The Earned Income Tax Credit (EITC) is a refundable credit for low- to moderate-income working individuals and families, with the maximum credit for 2024 ranging from $632 to $7,830 depending on the number of children.

Some credits are partially refundable, like the American Opportunity Tax Credit (AOTC) for college expenses. The AOTC provides a credit of up to $2,500, with up to $1,000 being refundable. The Child Tax Credit is worth up to $2,000 per qualifying child for 2024, and up to $1,700 of this is refundable through the Additional Child Tax Credit.

Tax Payments and Filing Procedures

The U.S. tax system requires individuals to pay taxes on income as it is earned. For employees, employers use Form W-4 to determine how much federal income tax to withhold from each paycheck. This is one of the two primary mechanisms for fulfilling this obligation.

Individuals with income not subject to withholding, such as from self-employment or investments, must often make quarterly estimated tax payments. These payments are calculated using Form 1040-ES and are due on April 15, June 15, September 15, and January 15. Estimated taxes are required if a person expects to owe at least $1,000 in tax and if their withholding and credits are less than 90% of their current year’s tax or 100% of their prior year’s tax (110% for higher-income taxpayers).

The tax year culminates with filing an annual income tax return, Form 1040, by the April 15 deadline. This filing reconciles all income, deductions, and credits with payments made through withholding and estimated taxes. If unable to file by the deadline, a taxpayer can request an automatic six-month extension to October 15 by filing Form 4868.

This is an extension of time to file, not to pay. Any tax owed is still due by the original April deadline and should be paid with the extension request to avoid penalties and interest. Tax returns can be submitted electronically through tax software or by using the IRS Free File program, or mailed as a paper return.