Federal income tax: Rules & ways to reduce your tax burden

Federal income tax: Rules & ways to reduce your tax burden

05.03.2024

The federal income tax is a tax the federal government imposes on the money each individual earns, whether it’s through a full-time job, a business they own, or their investments.

The federal income tax dates back to the Civil War when President Lincoln signed the nation’s first tax into effect to pay for the war efforts. Income taxes would come and go throughout the following half-century until the ratification of the 16th amendment, which gave the federal government the power to collect income taxes.1

The purpose of the federal income tax is to fund the U.S. government. Though there are other types of taxes and government revenue, income taxes represent the single largest source of revenue for the federal government, followed by Social Security and Medicare taxes and then corporate income taxes.2

The money the government raises in income taxes and other revenue sources is then spent on expenditures that include (in order of amount):

  • Social Security
  • National defense
  • Healthcare
  • Net interest
  • Medicare
  • Income security
  • Veterans' benefits and services
  • Commerce and housing credit
  • Education, training, employment, and social services
  • Transportation
  • Other expenses

Each person who has income in the United States, whether it’s earned income through a job or income from some other source, is required to pay federal income taxes.

We’ll cover how federal income taxes work and strategies to reduce your federal income tax liability through tax deductions and credits.

Types of taxable income

The most common type of taxable income is the earned income you receive from your job. This includes any wages, salaries, commissions, fees, and tips. However, according to the IRS, there are also many other types of taxable income. The IRS breaks taxable income down into six different categories:

Income category

Income types

Employment

Wages and employee benefits

Self-employment

Freelance or independent contractor income

Income from the sale of goods and services

Gig work income

Rental income

Bartering

Royalty income

Businesses

Income from partnerships and other business entities

Investments

Capital gains

Stock options, splits, or trades

Interest

Dividends

Digital assets

Benefits

Retirement distributions, pensions, and annuities

Unemployment benefits

Social Security income

Some life insurance proceeds

Some survivor benefits

Other

Tax refunds, reimbursements, and rebates

Canceled debt

Alimony payments

Court awards and damages

Some scholarships

Gambling winnings

Prizes and awards

Different types of income may be taxed in different ways. For example, your capital gains, meaning the amount you make when you sell an asset for more than you paid for it, are taxed differently than the income you earn at your job. If you have more than one type of income, it’s important to use the appropriate tax forms to ensure you’re paying the correct tax rate and type on each form of income.

Gross income vs. net income

As you learn about federal income taxes, it’s important to understand the difference between your gross income and your net income.

Your gross income is your total earnings. For example, if your employer pays you a salary of $100,000, then your gross income is $100,000. However, you likely don’t actually get $100,000 from your paychecks. Instead, money is taken out for taxes, benefits, and other withholdings. The amount you earn after taxes and deductions is your net income.

Throughout the year, your employer withholds money from your paychecks to pay for various forms of taxes, including income taxes, Social Security taxes, and Medicare taxes. However, the amount your employer withholds isn’t necessarily the amount you owe, as anyone who has ever gotten a tax refund or owed taxes at the end of the year knows.

The amount your employer withholds is based on the information you provide on your Form W-4. However, if the information on your W-4 doesn’t give an accurate picture of your financial and tax situation, it could result in your employer withholding too much or too little.

At the end of the day, while your gross income is an important figure, your net income has a greater impact on your day-to-day life because it represents the amount you actually have available to spend on living expenses and other costs.

Filing federal income taxes

Each year, the federal government requires that all individuals and entities file annual income taxes and pay their federal tax bills. Taxes are generally filed and paid to the IRS by April of each year.

The primary tax form that people use to file their income taxes is IRS Form 1040, U.S. Individual Income Tax Return. However, there are different versions of this form, depending on your situation. Here are some of the forms:

  • Form 1040: Used by individuals who have incomes above $50,000, who are itemizing their deductions, who have self-employment income, and/or who have income from the sale of property.
  • 1040-SR: U.S. Tax Return for Seniors, is available as an optional alternative to using Form 1040 for taxpayers who are age 65 or older. Form 1040-SR uses the same schedules and instructions as Form 1040 does.

In addition to the main tax form, there are a variety of schedules someone might have to complete to accompany their Form 1040. Those schedules may include:

  • Schedule 1, Additional Income and Adjustments to Income
  • Schedule 2, Additional Taxes
  • Schedule 3, Additional Credits and Payments
  • Schedule A, Itemized Deductions
  • Schedule B, Interest and Ordinary Dividends
  • Schedule C, Profit or Loss from Business
  • Schedule D, Capital Gains and Losses
  • Schedule E, Supplemental Income and Loss
  • Schedule EIC, Earned Income Credit
  • Schedule F, Profit or Loss From Farming
  • Schedule H, Household Employment Taxes
  • Schedule J, Income Averaging for Farmers and Fisherman
  • Schedule R, Credit for the Elderly or Disabled
  • Schedule SE, Self-Employment Tax
  • Schedule 8812, Credits for Qualifying Children and Other Dependents

Understanding federal income tax brackets

The federal government has a progressive tax system, meaning the higher your income, the higher your tax rate. There are seven tax brackets, each with a different tax rate. As of 2024, the seven federal tax rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The table below shows the tax brackets for a single filer in 2024:

Tax rate

Income range

10%

$0 to $11,600

12%

$11,601 to $47,150

22%

$47,151 to $100,525

24%

$100,526 to $191,950

32%

$191,951 to $243,725

35%

$243,726 to $609,350

37%

$609,351 or more

Read more: Income tax brackets unveiled

The way the marginal tax system works, each portion of your income is taxed at the rate that corresponds to the tax bracket it falls into. For example, if you are a single filer and you have taxable income of $100,000, meaning you fall into the 22% tax bracket, you don’t pay a 22% tax rate on all of your income. Instead, you pay 10% on the first $11,600, and so on.

The purpose of the progressive tax system is to ensure that high-income earners who can afford to pay more do so while those with lower incomes are able to keep more of their money for living expenses. While the tax rates and income rates for those brackets have changed over time, the progressive nature of our tax system hasn’t.

Distinguishing marginal tax rate vs. effective tax rate

Many people pay a lot of attention to their marginal tax rate, meaning the tax rate that applies to the highest portion of their income. Another way of evaluating your tax burden is by considering your effective tax rate, also known as your average tax rate, which can be found by dividing your total tax bill by your total income.

Your effective tax rate is likely lower than your marginal tax rate because of tax deductions and credits and the fact that different portions of your income are taxed at different marginal tax rates.

Suppose you, a single filer, had taxable income of $80,000 in 2023, putting you in the 22% marginal tax bracket. But only $35,275 of your income is taxed at 22%. The first $11,000 is taxed at just 10%, while another $33,725 is taxed at 12%. When you run the numbers, your effective tax rate is just 16%.

We’ll talk in later sections about applying tax deductions and credits, but those are examples of provisions to help you achieve a lower effective tax rate.  According to the Tax Foundation, the average effective tax rate was only 13.6% in 2020.3

Maximizing tax benefits: Leveraging tax deductions

A tax deduction is a legislative provision that allows you to reduce your taxable income, therefore reducing your total tax liability.

Let’s say you have an annual income of $50,000 per year. Any tax deductions you’re eligible for would reduce that number. For example, if you qualified for a $5,000 deduction, it would reduce your taxable income to $45,000.

When your tax rate is calculated, it’s done after deductions have been applied. Because your tax rate applies to a lower number, you end up paying less in taxes. In fact, depending on how close you are to the lower limit of your tax bracket, tax deductions could push you down into a lower marginal tax bracket.

Read more: How to reduce taxable income: Can the average American pay no taxes?

Types of tax deductions

When you file your taxes, you can choose to either itemize your deductions or claim the standard deduction. The standard deduction is available to anyone who doesn’t itemize their deductions.

For 2024 tax returns, the standard deduction is $14,600 for single filers and $29,200 for married filers. Each year, you should assess your tax situation and determine whether the standard deduction or itemizing your deductions would lower your taxable income more.

Deductions can be broken down into two general categories: above-the-line and below-the-line deductions. The “line” in reference is the line upon which Adjusted Gross Income (AGI) is reported. The significance of AGI is that it serves as a reference point throughout the return for determining eligibility for many provisions including certain deductions and credits.  Above-the-line deductions are part of the calculation to determine AGI. Meanwhile, below-the-line deductions are applied on lines appearing below the line where AGI is reported, hence the reference to above-the-line and below-the-line deductions. Above-the-line deductions are generally more beneficial than below-the-line deductions.

These are examples of above-the-line deductions you may qualify for:

  • Business use of a home or vehicle
  • Retirement contributions
  • Health savings account contributions
  • Student loan interest
  • Teacher expenses (up to $300)
  • Certain work-related education expenses
  • Capital losses

These are below-the-line deductions you may qualify to claim (limitations may apply):

  • Standard Deduction
  • Itemized Deductions, possibly including:
    • Charitable contributions
    • Gambling losses
    • Home mortgage interest
    • State and local taxes
    • Medical expenses that exceed 7.5% of your AGI

Understanding tax credits for reducing federal taxes

A tax credit directly reduces the amount of taxes you owe. Unlike tax deductions, credits apply after your tax liability has been calculated, and then reduce that liability on a dollar-for-dollar basis.

For example, suppose that after taking any deductions you’re eligible for, you calculate your federal income tax and find that you owe $5,000. Any tax credits you’re eligible for directly reduce your tax bill. Suppose you have one child and qualify for the child tax credit, which is $2,000. Your tax liability goes from $5,000 to $3,000. If you have two children, you can subtract $4,000 from your tax bill, bringing your tax liability to just $1,000.

Some of the most commonly claimed tax credits are:

  • Earned Income Tax Credit
  • Child Tax Credit
  • Child and Dependent Care Credit
  • American Opportunity Tax Credit
  • Retirement Savings Contributions Credit
  • Health Insurance Premium Tax Credit

Some tax credits have income caps in place to limit who may use them. For example, the Earned Income Tax Credit (EITC) is designed for low and moderate-income families. Meanwhile, though the Child Tax Credit doesn’t help only low-income families, it does have an income limit of $200,000 for a single filer or $400,000 for joint filers.

Distinguishing refundable vs. nonrefundable tax credits

Tax credits can be either refundable or nonrefundable. A refundable tax credit is one you can receive even if it exceeds your total tax liability. If a tax credit is nonrefundable, you won’t receive any portion of the credit that exceeds your tax liability.

For example, suppose you’re a low-income earner, and your total income tax liability for the year is only $1,000. You qualify for a $2,000 tax credit. If the tax credit is refundable, you will receive the entire amount. However, if the tax credit is nonrefundable, you’ll only receive $1,000 of it.

Tax credits can also be partially refundable. For example, the American Opportunity tax credit, which helps pay for qualified education expenses, is partially refundable. You can receive 40% of the credit after you’ve zeroed out your tax liability, for a maximum of $1,000.

Read more: How long does it take to get a tax refund?

Understanding state income tax and federal income tax

When you have taxable income, you don’t just pay taxes at the federal level. In most cases, you must also pay state income taxes. These taxes are entirely separate, and the amount you pay in federal taxes doesn’t reduce the amount you must pay in state taxes.

A handful of states — Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, and Wyoming — have no state income tax. However, these states generally collect tax from other sources, such as property taxes or sales taxes.

There are also several states with a flat income tax, meaning all taxpayers pay the same rate, regardless of their income. Finally, the majority of states have progressive income tax rates, just like the federal tax code.

The amount you’ll pay in state income taxes depends on where you live and your income level. Rates generally range from as low as 1% for the lowest earners in some states to more than 10% for the highest earners in a few states.4

Understanding different entities in federal taxation

Most people think only about how the federal tax code affects them individually, but it’s worth noting that entities other than individuals are subject to taxes as well. And it’s important to have at least a basic understanding of them in case these codes apply to you one day.

Certain types of businesses, including sole proprietorships and some limited liability companies (LLCs), are considered pass-through entities. Any income earned by these businesses passes directly to the owners. The business itself generally doesn’t pay income taxes — each owner pays income taxes on their share of the profits.

However, other businesses, such as many corporations, are taxed as separate entities. The business files its own tax return, wher it may be eligible for credits and deductions. It pays taxes on its taxable income.

Nonprofit and charitable organizations also have unique tax rules. These organizations are often tax-exempt, meaning they may not have to pay state or federal taxes. However, there are many requirements that organizations must meet to enjoy this status, both upfront and on an ongoing basis.

Finally, there are regulations applying to international entities. Foreign entities, including individuals, businesses, and nonprofit organizations, must generally pay taxes on the income they earn in the United States. In some cases, treaties with other countries may help to reduce someone’s tax liability. These individuals and organizations are also subject to certain withholding rules.

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1 IRS, “Historical Highlights of the IRS,” https://www.irs.gov/newsroom/historical-highlights-of-the-irs, accessed February 12, 2024.

2 Fiscal Data, “Government Revenue,” https://fiscaldata.treasury.gov/americas-finance-guide/government-revenue/, accessed February 12, 2024.

3 Tax Foundation, “Summary of the Latest Federal Income Tax Data, 2023 Update,” https://taxfoundation.org/data/all/federal/summary-latest-federal-income-tax-data-2023-update/, accessed February 12, 2024.

4 Tax Foundation, “State Individual Income Tax Rates and Brackets for 2023,” https://taxfoundation.org/data/all/state/state-income-tax-rates-2023/, accessed February 12, 2024.

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Gregory J. King, CPA

Gregory J. King, CPA

Contributor

Greg King is a Tax Specialist at Empower. A Certified Public Account, he is responsible for reviewing and identifying inefficiencies and opportunities for client portfolios, estates, and tax situations.

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