The federal income tax is imposed by the federal government on individual earnings. This includes income from a person’s full-time job, a business they own, or their investments.

The federal income tax originated during the Civil War, introduced by President Lincoln to fund wartime efforts.¹ Income taxes would come into force intermittently until 1913, when the ratification of the 16th Amendment gave the federal government the power to collect income taxes.

The purpose of the federal income tax is to fund the U.S. government. Although there are other types of taxes and government revenue, individual 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):³
 

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

Almost every person who earns income in the United States, regardless of the source, is required to pay federal income taxes.⁴

Understanding how federal income taxes work is essential to finding strategies that may help reduce your federal income tax liability through tax deductions and credits.

Types of taxable income

The most common type of taxable income is wages earned from employment. 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 classifies taxable income into six categories:⁵

Different types of income may be taxed in different ways. For example, capital gains, the profit made from selling an asset for more than the purchase price, are taxed differently than the income earned from work. People who have more than one type of income should ensure they use appropriate tax forms to ensure they’re paying the correct tax rate and type on each form of income.

Gross income vs. net income

When learning about federal income taxes, it’s important to understand the difference between gross income and 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. You likely don’t actually get the full $100,000 from your paycheck, however. Instead, money is taken out for taxes, benefits, and other withholdings. The amount you earn after taxes and deductions is your net income.

Your employer withholds money from your paychecks throughout the year to pay for various forms of taxes, including income taxes, Social Security taxes, and Medicare taxes. 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, then your employer may be withholding too much or too little.

Although your gross income is a useful metric when you track your personal finances, your net income has a greater impact on your day-to-day life. This figure represents the amount you actually have available to spend on living expenses and other costs.

Filing federal income taxes

Every 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 with an income above $50,000 who are itemizing their deductions, who have self-employment income, or have income from the sale of property.
• 1040-SR: U.S. Tax Return for Seniors, is available as an alternative to Form 1040 for taxpayers who are aged 65 or older. Form 1040-SR uses the same schedules and instructions as Form 1040, but comes with a simpler layout and callouts to specific deductions relevant to seniors.

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 single filers and married couples filing jointly in 2024:⁵

Read more: Income tax brackets unveiled

Under a progressive marginal tax system, each portion of your income is taxed at the rate that corresponds to the tax bracket it falls into.⁶ For example, if you are a single filer and you have taxable income of $100,000, you fall into the 22% tax bracket. Instead, you pay: 

• 10% on the first $11,600
• 12% on $11,601 through $47,150,
• 22% on $47.151 through $100,525 

The purpose of this 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. Tax and income rates within these brackets have changed over time, but the progressive nature of the tax system has not.

Distinguishing marginal tax rate vs. effective tax rate

You can also evaluate your tax obligations 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. The average effective tax rate was 24.2% in 2023.⁷

For example, a single filer with taxable income of $80,000 in 2024 is in the 22% marginal tax bracket. However, not all of their income is taxed at this rate. The first $11,600 is taxed at 10%, the next $35,550 (from $11,601 to $47,150) is taxed at 12%, and the remaining $32,850 (from $47,151 to $80,000) is taxed at 22%. Despite the highest portion of their income being taxed at 22%, their overall effective tax rate will be lower, around 14%, because much of their income is taxed at the lower rates. 

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 $60,000 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 $55,000.

Your tax rate is calculated after deductions are applied. Because deductions lower your taxable income, your tax rate applies to a smaller figure. Thus, you will typically pay less in taxes than without those deductions. Depending on how close you are to the lower limit of your tax bracket, these deductions may even 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 couples filing jointly.⁸ You may find itemizing deductions is a better move depending on whether or not doing so would lower your bill beyond the standard deduction, or if it would affect your tax bracket. Speak with a tax professional for personal guidance.

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. AGI serves as a reference point throughout the return for determining your eligibility for certain provisions, such as certain deductions and credits. 

Above-the-line deductions are part of the calculation to determine AGI. Meanwhile, below-the-line deductions apply to lines that appear below the line where AGI is reported. Above-the-line deductions are generally more beneficial than below-the-line deductions, as they are more universally beneficial and do not apply to your gross income.⁹ They are available to all taxpayers and can help lower your AGI.

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 (tuition, supplies, and certain transportation costs, among others)
• 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

Tax credits directly reduce the amount of tax 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.

Say for example that you have a remaining balance on your tax bill after claiming every eligible deduction. Tax credits would typically lower your bill further. If you have one child and qualify for the child tax credit ($2,000 in 2024), your tax liability would decrease by $2,000. If you have two children, you could subtract $4,000 from your tax bill.

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.¹⁰ Meanwhile, though the Child Tax Credit doesn’t just help low-income families, it also has an income limit of $200,000 for a single filer or $400,000 for joint filers.¹¹

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, a low-income earner with a total income tax liability of $1,000 qualifies for a $2,000 tax credit. If the tax credit is refundable, they would receive the full $2,000 credit, potentially as a tax refund. However, if the tax credit is nonrefundable, they would only receive $1,000, as that is the total of their tax bill.

Tax credits can also be partially refundable. The American Opportunity tax credit is one example. Recipients can get 40% of the credit as a refund after zeroing out their tax liability.¹²

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, Washington, and Wyoming — have no state income tax.¹³ 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.¹⁴

Understanding different entities in federal taxation

State and federal tax codes don’t just affect people personally. Entities other than individuals, such as sole proprietorships, certain limited liability companies (LLCs), and other pass-through entities, may also impact your tax bill. Pass-through entities do not pay their own separate tax bill.¹⁵ Rather, the other of the entity is responsible for paying tax on the income they receive through the business.

Other businesses, such as corporations, are typically taxed as separate entities.¹⁶ These businesses file their own tax return based on taxable income, and may be eligible for their own credits and deductions.

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.¹⁷ 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.¹⁸ 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.

Being prepared for tax time

Understanding federal income taxes doesn’t have to be overwhelming. By knowing how your income is taxed and what deductions or credits you may qualify for, you can take steps to reduce your tax bill. Whether that’s through deductions that lower your taxable income or credits that directly reduce what you owe, there are ways to optimize your return.