Income Tax

Income taxes are taxes collected by federal, state and local governments on the income of individuals and businesses. These taxes are typically applied to a percentage of the income, but the rate may vary based on the type of income, amount of income or the type of taxpayer.

Terry Turner, Financial writer for Annuity.org
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APA Turner, T. (2022, June 11). Income Tax. Annuity.org. Retrieved June 22, 2022, from https://www.annuity.org/personal-finance/taxes/income-tax/

MLA Turner, Terry. "Income Tax." Annuity.org, 11 Jun 2022, https://www.annuity.org/personal-finance/taxes/income-tax/.

Chicago Turner, Terry. "Income Tax." Annuity.org. Last modified June 11, 2022. https://www.annuity.org/personal-finance/taxes/income-tax/.

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What Are Income Taxes and How Do They Work?

Income taxes are one of several different types of taxes governments rely on to fund public services.

The federal government in the United States uses a progressive income tax system in which your tax rate increases as your income increases. This produces a series of tax brackets in which different blocks of your income are taxed at different rates.

Primary Types of Income Taxes
Individual Income Tax
Individual income tax — or personal income tax — is the tax individuals pay on their personal salary, wages or other taxable earnings. Most people don’t pay taxes on all their income thanks to deductions, tax credits and exemptions.
Business (or Corporate) Income Tax
Business earnings from small businesses, corporations, self-employed individuals, partnerships and other business arrangements are also subject to income taxes. A business income tax typically applies to the income after subtracting capital and operating expenses from the business’ revenue.

The individual income tax produces about five times as much tax revenue for the federal government than the business income tax, according to the U.S. Department of the Treasury.

The IRS collects federal income taxes and enforces federal tax law in the United States. It manages and oversees the complex set of tax regulations created by the federal tax code.

Federal income taxes are collected on all types of income including wages, salaries, commissions, business earnings, interest and investments.

State and local governments may also impose income taxes, but rates and methods for taxing income vary between jurisdictions.

Income taxes play a major role in most people’s personal finances. So, it’s important to understand what your income tax options are when laying out your personal financial planning.

Federal, State and Local Income Taxes

Federal, state and local income taxes account for the largest portion of government revenue in the United States — 41.5 percent of all tax revenue in 2019, according to the Tax Foundation.

Federal Income Tax

The foundation of the federal income tax is that Americans are taxed based on their ability to pay. Even though taxpayers may have the same income, they may not be able to pay the same amount. This may be due to high medical bills, mortgage interest or other financial obligations or burdens.

To make the income tax more fair, people can claim tax exemptions, deductions and credits. These lower the taxable income of taxpayers in some situations making them more able to pay income tax.

How to Estimate Your Income Taxes
The easiest way to estimate how much federal income tax you will owe is to use the tax withholding estimator. You can use this online tool to fill out your W-4 Form so that you don’t have too much — or too little — income tax withheld from your paycheck.
Source: IRS

The federal income tax is a voluntary system — but paying it is not optional. The IRS relies on each income earner to voluntarily report their income and calculate the taxes they owe when they file a tax return each year.

The first federal income tax was levied during the Civil War, but court rulings following the war declared the income tax unconstitutional. The federal income tax was reinstated with the passage of the 16th Amendment in 1913.

State and Local Income Taxes

In addition to the federal income tax, you may also have to pay state or local income tax depending on where you live.

Among the states, 41 of them — along with the District of Columbia — tax wages and salaries as income. California holds the top marginal rate for taxable income at 13.3 percent.

The remaining eight states do not collect income taxes.

States that Do Not Collect State Income Taxes
  • Alaska
  • Florida
  • Nevada
  • South Dakota
  • Tennessee
  • Texas
  • Washington
  • Wyoming
Source: Tax Foundation

Most local governments do not collect local income taxes. But as of 2019, nearly 5,000 local governments, spread across 17 states, levied some amount of local income taxes.

State and Local Income Tax Jurisdictions Table
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Two states — Ohio and Pennsylvania — account for nearly 78 percent of all jurisdictions that levy local income taxes. This includes 3,155 cities and 671 school districts.

Income tax rates vary widely between states and localities that levy them. To find out your state and income tax rate, you should contact your state tax agency.

Who Pays the Federal Income Tax in the U.S.?

In the United States, individuals, businesses and other entities such as estates and trusts pay income taxes.

Breaking down data from the 2018 tax year, the Tax Foundation looked at the amounts people of different income levels paid in federal individual income taxes.

It found the highest earning half of taxpayers pay 97 percent of federal income taxes. The bottom 50 percent of income earners paid the remaining 3 percent. The average adjusted gross income of the bottom 50 percent was about $18,600.

Share of Adjusted Gross Income & Federal Income Tax Payments by Income Group Graph
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Typically, more affluent Americans pay higher income taxes while people in lower income groups pay a greater percentage of their earnings toward payroll and excise taxes. Taxpayers in the bottom 90 percent of incomes in the United States pay more in payroll taxes than income taxes, according to the Peter G. Peterson Foundation.

Individual income taxes accounted for $1.6 trillion in federal revenue in 2020, according to the Congressional Budget Office. That was nearly half of all revenue the federal government took in that year. Corporate income taxes accounted for another 6 percent of federal revenue — an additional $212 billion.

Please seek the advice of a qualified professional before making financial decisions.
Last Modified: June 11, 2022

11 Cited Research Articles

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