What Are Income Taxes and How Do They Work?

Income tax is a required payment levied by a government on the income of individuals and businesses, serving as a primary source of funding for public services. The tax is not a flat fee but is calculated as a percentage of earnings, with the amount owed being proportional to the income generated. By law, individuals and entities must report their income annually to determine their tax obligation. The specific rules and rates are established by law and can change over time.

Sources of Taxable Income

The foundation of income tax is gross income, which encompasses all income from any source unless specifically exempted. The Internal Revenue Service (IRS) defines income broadly to include money, property, or services received. Nearly every form of compensation or financial gain must be accounted for when determining tax obligations.

Earned Income

Earned income is the most common category and includes compensation for personal services. This consists of wages, salaries, tips, and bonuses paid by an employer to an employee. The category also extends to self-employment earnings, which is income generated from a trade or business an individual operates themselves, such as a freelancer or independent contractor.

Investment Income

Investment income, also known as unearned income, is generated from owning assets. This includes interest from bank accounts or bonds and dividends from owning stock. Capital gains are another form, realized when an asset like stocks or real estate is sold for more than its purchase price. The tax treatment of capital gains can depend on how long the asset was held before the sale.

Passive Income

Passive income is derived from activities where an individual does not materially participate, such as real estate rentals. If you own and lease a property, the rent payments are passive income. Another source is income from a limited partnership, where an individual invests in a business but is not involved in its daily operations.

Other Common Income

Several other types of income are also subject to taxation.

• Unemployment compensation received is considered taxable income.
• Distributions from retirement plans like a traditional 401(k) or IRA are taxable in the year they are received.
• Winnings from gambling, including lotteries and raffles, are fully taxable.
• Income from bartering is taxable at the fair market value of the goods or services exchanged.

Key Components of Tax Calculation

The final amount of tax you owe is based on your taxable income, which is determined after several adjustments and deductions are made to your gross income. This system is designed to base your tax liability on your ability to pay, rather than your total earnings.

Adjusted Gross Income (AGI)

The first step in refining gross income is calculating your Adjusted Gross Income (AGI). AGI is your gross income minus specific “above-the-line” deductions. Common examples include contributions to a traditional IRA, student loan interest, and certain business expenses for the self-employed. AGI is used to determine eligibility for various tax credits and other deductions.

Deductions (Standard vs. Itemized)

After determining AGI, you subtract deductions to lower your income subject to tax. Taxpayers choose between a standard deduction or itemizing deductions. The standard deduction is a fixed dollar amount based on filing status, age, and whether you are blind, and it is adjusted annually for inflation.

Alternatively, you can itemize deductions by listing specific eligible expenses. These can include state and local taxes (SALT), mortgage interest, charitable contributions, and medical expenses exceeding 7.5% of your AGI. The SALT deduction is capped at $10,000 per household through 2025. Taxpayers choose to itemize only if their total itemized deductions exceed their available standard deduction.

Taxable Income

Your taxable income is the figure used to calculate your tax liability. It is determined by subtracting your chosen deduction (standard or itemized) from your Adjusted Gross Income. This is the amount of income the government taxes according to the established rates.

Tax Brackets and Progressive Taxation

The United States uses a progressive tax system, meaning higher portions of income are taxed at higher rates. Your taxable income is divided into segments known as tax brackets, each with a corresponding marginal tax rate. For example, a portion of your income is taxed at the lowest rate, the next portion at the next higher rate, and so on. This structure ensures only the income within a specific bracket is taxed at that bracket’s rate.

Tax Credits

Tax credits provide a dollar-for-dollar reduction of the tax you owe, unlike deductions which only reduce your taxable income. A $1,000 tax credit reduces your tax bill by $1,000. Common examples include the Child Tax Credit and education credits. Some credits are refundable, meaning you can receive the difference back as a refund if the credit is larger than your tax liability.

Federal State and Local Income Taxes

The income tax system in the United States is multi-layered, with taxes imposed by federal, state, and sometimes local governments. Each level of government has its own rules and rates. A taxpayer’s total income tax burden is a composite of these different obligations.

Federal Income Tax

The federal income tax is the most significant for most U.S. taxpayers and is administered by the IRS. It is a progressive tax with rates that increase as income rises. The rules for federal income tax are established by federal law and apply uniformly across all states.

State Income Tax

Most states also levy their own income tax in addition to the federal tax. State systems vary, with some using a progressive system and others applying a flat tax rate to all income levels. Nine states do not impose a broad-based personal income tax:

• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming

Washington and New Hampshire, however, do tax certain investment income.

Local Income Tax

A third tier of income tax can come from local governments like cities or counties. These taxes are less common but are a reality for residents in certain areas. Local income taxes are often a small, flat percentage of earned income levied on top of federal and state taxes to fund local services.

The Tax Filing Process

The tax filing process is the annual procedure for reporting income, calculating tax liability, and settling obligations with the government. Adherence to deadlines is required and the process determines whether a taxpayer receives a refund or owes additional tax.

Gathering Your Documents

The first step in filing is to collect all necessary financial documents. This includes a Form W-2 from each employer and various Form 1099s, which report other income like freelance work (1099-NEC), interest (1099-INT), or dividends (1099-DIV). If you plan to itemize, you will also need receipts for expenses like charitable donations and mortgage interest.

Choosing a Filing Method

Once you have your documents, you must decide how to prepare and file your return. Common methods include:

• Using tax preparation software, which guides you through the process.
• Using free filing options like IRS Free File or the IRS Direct File service, which became a permanent option in 2025.
• Hiring a tax professional, such as a Certified Public Accountant (CPA) or an Enrolled Agent.
• Filling out paper forms by hand and mailing them, though this is less common.

Submitting the Tax Return

After completing the return, you must submit it to the IRS. The most efficient method is electronic filing (e-filing), which offers faster processing and confirmation. Filing by mail can take six to eight weeks or longer to process. The standard deadline to submit your return is April 15, but an extension can be requested, which pushes the deadline to October 15.

Handling the Outcome

The final step is managing the result. If your return shows you overpaid, you are due a refund, which can be received via direct deposit or paper check. If you owe additional tax, you must pay the IRS by the April deadline to avoid penalties and interest. If you cannot pay the full amount, the IRS offers payment plans to help manage the debt.