Income Tax is a common tax that most people globally will pay if they're earning any kind of income. But there are many rules - and deductions - to know about. Learn everything you need to know about Income Tax in our essential guide.
- Income Tax is the most common type of tax imposed by governments on income generated by individuals. It's used to fund public services, pay government debts, and more.
- Most countries, including the USA, have progressive tax systems where portions of your taxable income fall into different tax brackets and are taxed at different rates.
- The US Federal Income Tax rate is between 10% to 37%. Some states also impose a state-level Income Tax.
- Tax brackets are adjusted each year for inflation.
What is Income Tax?
Income Tax is a tax that governments impose on individual taxpayers (and sometimes businesses) on any income earned within a given jurisdiction. Income Tax is generally the largest source of revenue for governments worldwide. Each country will have different rates and taxation systems affecting the amount of Income Tax that taxpayers may be liable to pay.
Why is income taxed?
Taxes, including Income Tax, fund different public services throughout the country. In most cases, this includes health services, social services, educational services, transport, and more.
Income Tax isn’t the only tax used to raise revenue for governments, but it makes up a significant proportion of government funding each fiscal year. Without it, or when there are significant tax cuts implemented, you may see a shortage of public service funding and a significant decrease in the quality of public services.
Do I have to pay Income Tax?
Yes. Generally, wherever you live in the world, if you're earning an income, you'll pay tax on that income. Some countries do have a threshold at which Income Tax applies, so a portion of overall income would be tax free. But this is usually a fairly low amount, and indeed, other countries including the US, do not have any tax free threshold for income.
What percent of income is taxed?
Normally the answer to this is pretty simple - the more you earn, the more you pay. Most of the time, governments use a progressive tax system, meaning the percent of your income that's taxed depends on how much you earn, as well as potentially your filing status (whether you're single, married, or so on).
For example, in the US, Federal Income Tax rates are between 10% to 37% based on annual income and your filing status. Learn more about US tax rates.
How Income Tax brackets work
Tax brackets refer to the different percentage rates in a given progressive tax system. For example, the 12% tax bracket or the 24% tax bracket. But in a progressive taxation system, this doesn't mean that you're paying that percentage of tax on your entire income, instead as you earn more, you'll be taxed at a higher rate on your higher earnings.
Let's say you earned $70,000 in a financial year in the US. You’d pay 10% tax on the first $14,650, 12% on the next $41,249 (so up to the $55,900 cut off), and 22% on the final $14,099 of your income.
This example doesn't however take into consideration State Income Taxes, so depending on the state you live in, you may be liable to pay additional tax at either a flat or progressive rate.
Finally, it's important to note that Income Tax brackets are adjusted annually for inflation in the US, so your tax brackets last year won't be the same as your tax brackets next year.
How do I calculate Income Tax?
To calculate Income Tax, add up all the sources of taxable income earned in a given financial year. Your total taxable income includes:
- Your salary and wages on Form W-2
- Any income from self-employment
- Any income reported on 1099 forms like investment dividends, taxable interest, broker and barter exchange transactions
- Capital gains
- Business income
- Farm income
- Taxable refunds and credits
- Security deposits and rental property income
- Prizes, lottery winnings, gambling winnings and other awards
- …and more!
Fortunately, not quite all of your income is taxable. Income that is not taxed includes:
- Child support benefits
- Life insurance proceeds (generally)
- Workers' compensation benefits
- Disability payments
- Capital gains from the sale of your primary home
- Money received as a gift or other inherited assets
- Scholarships or fellowship grants
Once you have your total taxable income, you need to calculate your adjusted gross income (AGI). Your AGI is your total taxable income, minus any allowable deductions or expenses, like the self-employment tax deduction. But there are a lot of deductions available depending on your individual circumstances, so you should always seek the help of a professional and experienced accountant to make sure you pay the correct amount of tax.
Once you've subtracted any available deductions to arrive at your AGI, this will be the figure you'll pay tax on, according to the relevant tax brackets.
State, provincial and local Income Tax
We've focused on Federal Income Tax so far, but depending on where you live, you may also be liable for additional state taxes. State taxation is decided at state-level, so each state does it a little differently, some states impose no tax at all, other states have a flat state Income Tax, and other states adopt a similar progressive taxation system to the federal system. Find out more about state income taxes.
In other countries, these state taxes may also be known as provincial taxes, municipality taxes, or canton taxes.
If you're employed, your employer will generally have to deduct any wage-based taxes on your behalf, for example, social security and medicare tax. If you're self-employed, you'll still need to pay these wage-based taxes, but you'll have to calculate it yourself.
What other kinds of tax are there?
Income Tax isn't the only tax you may be liable to pay. The other potential taxes in the US include:
- Capital Gains Tax
- Sales Tax
- Value Added Tax
- Corporate Income Tax
- Payroll Tax
- Gross Receipts Tax
- Excise Tax
Residents vs. non residents
All of the information in this guide so far has covered tax for residents - that is, citizens by birth or naturalization. Resident aliens - so non-citizens but legal residents with green cards - may be taxed differently. For these individuals, any income from foreign sources may also be taxable income in the US. This said, they may be able to claim the foreign-armed income exclusion or foreign tax credit to prevent double taxation, depending on the country where the income derives from and whether it has a tax treaty with the US.
More questions about Income Tax? We got you covered.
What is an effective tax rate?
An effective tax rate is the average tax rate paid in a progressive tax system. For example, if you fell into the 10%, 12% and 22% tax brackets, then your effective tax rate would be 14.6%.
What is a marginal tax rate?
Marginal tax rate refers to the tax rate paid for a particular portion of income under a progressive tax system. For example, you may pay a marginal tax rate of 10%.
What’s bracket creep?
Bracket creep refers to inflation pushing taxpayers into higher Income Tax brackets or the reduction of value of credits, deductions and exemptions due to inflation. Bracket creep results in an increase in Income Tax without the increase in income.
Why is income tax so high?
The answer to this isn't straightforward, as it really depends on who's asking it. In particular in the US, around 51% of Americans say the Income Tax they pay is not fair - with many low and middle income earners expressing concern over the lower tax rates paid by corporations and wealthy individuals.
Do you pay Income Tax on crypto?
Yes, you'll pay Income Tax on crypto if you're seen to be earning an additional income from crypto investments.
The information on this website is for general information only. It should not be taken as constituting professional advice from Koinly. Koinly is not a financial or taxation adviser. You should consider seeking independent legal, financial, taxation, or other advice to check how the website information relates to your unique circumstances. Koinly is not liable for any loss caused, whether due to negligence or otherwise arising from the use of, or reliance on, the information provided directly or indirectly, by use of this website.