The Internal Revenue Service (IRS) is responsible for collecting the U.S. federal income tax from individuals, corporations, trusts, and other legal entities. This tax is imposed on the yearly earnings of taxpayers, including various sources of income such as wages, salaries, commissions, bonuses, tips, investment income, and certain types of unearned income.
In the United States, federal income tax rates follow a progressive structure. This means that as a taxpayer’s taxable income increases, their tax rate also increases. The federal income tax rates range from 10% to 37% and are applied at specific income thresholds. These income ranges are known as tax brackets, and each bracket corresponds to a specific tax rate. The income within each bracket is taxed at the corresponding rate.
How Federal Income Tax Works
Cities, states, and countries collect taxes from individuals and corporations based on where they live or operate. When these taxes are credited to the government of the country, they are known as federal taxes.
The money collected through federal taxes is utilized by governments for various purposes, including the growth and maintenance of the country. Some people view federal tax as a form of “rent” paid to live in or use the resources provided by a country. When you pay taxes to the U.S. government, you are essentially investing in your economy. The government uses these funds to:
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- Build, repair, and maintain infrastructure
- Fund pensions and benefits for government workers
- Support Social Security programs
- Fund major health programs such as Medicare, Medicaid, CHIP, and marketplace subsidies
- Provide assistance to lower-income households through “safety net” programs
- Allocate funds for defense and international security programs
- Improve sectors like education, health, agriculture, utilities, and public transportation
- Undertake new endeavors such as space exploration
- Provide emergency disaster relief
In fiscal year 2023, the U.S. government collected $1.4 trillion in revenue while spending $1.93 trillion, resulting in a deficit of $460 billion.
The primary source of revenue for the federal government is the income of its residents. In 2021, the IRS collected approximately $4.1 trillion in total receipts, with individuals, estates, and trusts contributing $2.3 trillion, and business income taxes accounting for around $419 billion.
Types of Taxable Income
There are various types of income that are subject to taxation, and different tax rates may apply to each type. In general, there are two main categories of income: earned income and unearned income.
Earned income refers to the income that is primarily earned through employment, including self-employment. The most common forms of earned income include:
- Wages, whether received as a fixed salary or hourly pay.
- Income generated from business activities or operations.
- Pensions and other retirement benefits.
- Unemployment benefits received during periods of joblessness.
- Compensation received in the form of sick pay or other fringe benefits.
- Income earned through self-employment.
On the other hand, unearned income refers to income that is mainly generated through more passive forms of activity, particularly in the realm of investing. The most common forms of unearned income include:
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- Interest income or dividends earned from investments.
- Royalties or residual income derived from creative works or intellectual property.
- Rewards earned through staking or receiving airdropped cryptocurrency.
- Profits obtained from the sale of assets or investments.
It’s important to distinguish between gross income and net income. Gross income refers to the total amount of income earned before any deductions or expenses are subtracted. Net income, on the other hand, is the amount of income remaining after deducting applicable expenses, such as taxes, business costs, or investment-related expenses.
Gross Income vs. Net Income
Workers receive their earnings in two forms: net income (NI) or gross income. Net income, also known as take-home pay, refers to the total amount received after deducting taxes, benefits, and voluntary contributions from the paycheck. On the other hand, gross income represents the total amount earned before any deductions are made.
When taxes are withheld, it means that the company or payer has taken out the tax amount from the worker’s earnings and paid it to the government on their behalf. The specific amount withheld for taxes depends on the worker’s earnings and the information they provided to their employer using Form W-4.
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For federal tax purposes, all types of income are considered taxable, including wages, salaries, cash gifts from an employer, business income, tips, gambling income, bonuses, and unemployment compensation. It’s important to note that these sources of income contribute to the overall taxable income of an individual for federal tax calculations.