Introduction to Tax: How Taxes Work

A tax is a mandatory financial charge imposed by a government to fund its spending on public services and infrastructure. The U.S. Constitution grants the government the authority to levy taxes, which are the primary source of revenue for its operations. These funds are used for a wide range of public expenditures, including the construction and maintenance of roads and schools, national defense, law enforcement, and social programs like Medicare and Social Security.

Levels of Government Taxation

In the United States, the authority to impose and collect taxes is divided among three levels of government: federal, state, and local. This multi-tiered system means that individuals and businesses can be subject to taxes from different governing bodies. These levels of government may tax the same income or property, and the rules and rates can vary significantly from one jurisdiction to another.

Federal

The federal government’s taxing power is exercised through the Internal Revenue Service (IRS). Federal taxes are the largest source of revenue for the U.S. government and are used to fund national priorities. These include national defense, social insurance programs like Social Security and Medicare, and the development of national infrastructure. The primary tax levied at the federal level is the individual income tax.

State

Each state has its own set of tax laws and a corresponding agency for their administration. State tax revenues are used to fund services and programs that directly impact residents, such as state highway systems, public colleges and universities, and state police. The types of taxes levied vary by state, with many relying on a combination of income and sales taxes.

Local

Local governments, including counties, cities, and towns, levy taxes to pay for community-specific services. These taxes are the primary source of funding for public elementary and secondary schools, local police and fire departments, and local roads and parks. The most common form of local taxation is the property tax, assessed on the value of real estate and other personal property.

Common Types of Taxes in the U.S.

Individuals in the United States encounter various forms of taxation, which can be categorized based on what is being taxed: earnings, purchases, or ownership of assets. Understanding these common tax types is a part of managing personal finances.

Income Taxes

Income taxes are levied on the earnings of individuals and corporations. For individuals, this includes income from a wide range of sources such as wages, salaries, tips, interest, and dividends. The federal government and most, but not all, state governments impose an income tax.

Payroll Taxes (FICA)

Separate from income taxes, payroll taxes are specifically designated to fund the Social Security and Medicare programs. These taxes are mandated by the Federal Insurance Contributions Act (FICA). The FICA tax is split between employees and employers, with each paying a portion. For 2025, the Social Security tax rate is 6.2% for both the employer and the employee on wages up to $176,100, while the Medicare tax is 1.45% each, with no wage limit.

Sales Taxes

Sales taxes are applied to the price of goods and services at the time of purchase. While there is no federal sales tax, most states and many local governments levy them. These taxes are a form of consumption tax, meaning they are paid when you buy something.

Property Taxes

Property taxes are assessed by local governments on the value of real estate, such as a house or land. Some jurisdictions also tax personal property like vehicles or boats.

Capital Gains Taxes

A capital gains tax is imposed on the profit realized from the sale of an asset that has increased in value, such as stocks, bonds, and real estate. The tax is calculated on the difference between the asset’s selling price and its original purchase price. For federal tax purposes, the rate applied often depends on how long the asset was held, with assets held for more than one year taxed at a lower rate.

Estate and Gift Taxes

Estate and gift taxes are levied on the transfer of wealth from one person to another. The federal estate tax applies to the value of a person’s assets at death, before distribution to heirs, though a high exemption amount means very few estates are subject to it. The federal gift tax applies to the transfer of property for less than its full value.

Understanding Your Federal Income Tax

The federal income tax is a progressive tax, meaning that higher levels of income are taxed at higher rates. The calculation of your tax liability is a multi-step process that begins with determining your total income and then applying a series of adjustments, deductions, and credits, as outlined on Form 1040.

Income

The starting point for calculating federal income tax is Gross Income, which includes all income from sources such as wages, interest, dividends, and business income. From this amount, specific deductions are subtracted to arrive at Adjusted Gross Income (AGI). Taxable Income is then calculated by subtracting either the standard deduction or itemized deductions from AGI.

Deductions

Deductions work by reducing the amount of your income that is subject to tax. Taxpayers can choose between taking a standard deduction or itemizing their deductions. The standard deduction is a fixed dollar amount that varies based on filing status, age, and whether the taxpayer is blind. For the 2025 tax year, the standard deduction for a single individual is $15,000, and for married couples filing jointly, it is $30,000.

Itemized deductions are specific expenses that can be subtracted from AGI. Common itemized deductions include mortgage interest on a primary residence, state and local taxes up to a limit of $10,000 per household, and charitable contributions. Taxpayers choose to itemize if their allowable expenses exceed their standard deduction amount.

Tax Credits

Tax credits are more impactful than deductions because they provide a dollar-for-dollar reduction of your actual tax liability. A $1,000 tax credit reduces the amount of tax you owe by $1,000. Numerous tax credits are available, each with its own eligibility requirements. Common examples include the Child Tax Credit and the American Opportunity Tax Credit for educational expenses.

Tax Brackets and Marginal Rates

The U.S. federal income tax system uses marginal tax rates, which means that as your income increases, it is taxed in successive ranges, or “brackets,” at progressively higher rates. For the 2025 tax year, the federal income tax brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. It is a common misconception that all of your income is taxed at your highest bracket’s rate.

In reality, only the portion of your income within a specific bracket is taxed at that bracket’s rate. For example, a single individual with $50,000 in taxable income for 2025 would pay 10% on the first $11,925, 12% on the income between $11,926 and $48,475, and 22% on the income from $48,476 up to $50,000. Your marginal tax rate is the rate applied to your last dollar of income, while your effective tax rate is lower.

The Annual Tax Filing Cycle

The process of filing an annual income tax return involves a cycle of preparation and submission that takes place between January 1 and April 15 each year. This requires understanding what information is needed and the mechanics of submitting the return to the IRS.

Preparation and Key Decisions

Before a tax return can be filed, a taxpayer must gather all necessary financial documents. A Form W-2, which employees receive from their employers by January 31, details their annual wages and the amount of tax withheld. Individuals who are self-employed or receive other types of income, such as interest or dividends, will receive various versions of Form 1099. It is also important to collect records of any expenses that might be deductible.

During this preparation phase, taxpayers must make a decision on filing status: Single, Married Filing Jointly, Married Filing Separately, Head of Household, or Qualifying Surviving Spouse.

Filing and Post-Filing

Once all information is gathered, the next step is to complete and submit the tax return. Taxpayers have several options for filing, including using tax preparation software, hiring a tax professional, or mailing paper forms. The deadline for filing a federal income tax return is April 15. If more time is needed, a taxpayer can request an automatic six-month extension by filing Form 4868, which moves the filing deadline to October 15. An extension to file is not an extension to pay; any taxes owed are still due by the original April 15 deadline to avoid potential penalties and interest.