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What is the exact meaning of Federal Income Tax?

The federal income tax is the taxation of an individual’s or legal entity’s yearly earnings. The Internal Revenue Service (IRS) applies this to individuals, corporations, trusts and other entities with taxable incomes in which they earn their money from employment or capital gains.

KEY TAKEAWAYS

  • It is the largest source of revenue for the government.
  • It is used to build and repair infrastructure, improve education and public transportation, as well as provide disaster relief.
  • Nine states in the country do not have an income tax, which is different from federal taxes.

How Does it Work?

what is federal income tax

A tax is money collected by the government in which it resides or operates. When this collection is credited to their account, it becomes a federal tax.

Federal tax is the money used by the government of a country to pay for growth and upkeep. Tax can be seen as an investment, like renting space in your economy. You’re investing in infrastructure improvements, education opportunities, healthcare services etc. 

Federal tax is the money used by governments to pay for growth and upkeep. Some look at federal taxes as a “rent” fee charged to live in a country, or fees that allow you access to resources provided by your government. 

When you contribute funds towards American federal taxes, those are investments into our economy since they help provide funding for things like public infrastructure development projects such as roads and highways.

The IRS collected nearly $3 trillion in receipts from the income of its residents. In 2018, individuals and trusts contributed to this revenue with a total contribution of over 1/2 (almost) of it. People were compensated for their services mostly paid by cash or direct transfer into their bank accounts.

All money earned, whether as a wage or salary from an employer, business, income tips, earnings bonuses, unemployment compensation constitutes taxable federal income.

It is a progressive system in which people who make more money are taxed at higher rates. People below an annual threshold set by the government pay little to no taxes, while those earning six figures or more have mandatory tax rates that apply to their earnings. 

Tax brackets show how much of your taxable income you must give up as well as what rate it’s applied at and determine where one falls into this structure.

Income Tax vs. Federal Income Tax

The United States has many different kinds of income taxes like deferred income tax etc. Some states don’t have them and some others only tax dividends and interest incomes like New Hampshire, Tennessee, Washington State, Texas, Florida/Alaska/Nevada/South Dakota, they will not apply to wages or other types of earnings.

HISTORY

Over the 100-plus year history of income taxes, there have been many changes to brackets and rates. In 1913, Congress ratified the 16th Amendment which allowed for a federal income tax. 

The number of brackets quickly exploded from 7 in 1915 to over 50 by 1920. Since then until 1979, it has never dropped below 20 or increased above 90.

The last major federal tax reform, the Tax Reform Act of 1986, reduced the number of brackets from 16 to two and that has been slowly creeping back up ever since.

Currently, the federal tax brackets are seven in number. There is a tendency for this to increase over time with no concrete plan of action.

The top marginal income tax rate has varied widely over time. In the early 1960s, it was at 91 per cent before dropping to 70% with President Kennedy’s and Johnson’s first major tax cut in 1964. 

The Reagan Administration brought down the top federal income tax rate by 20 percentage points during their term of office (1981-1989). Once again, this year saw another drop after Congress passed a bipartisan bill supported by Clinton that decreased rates on both ordinary income as well as capital gains taxes from 39.6% back to 28%.

The American Taxpayer Relief Act of 2012 allows the reduced top rate to expire as scheduled. The recent change, however, cut it down by an additional 0.6% again before 2018 making a new tax bracket that went into effect on January 1st at 37%.

State Income Tax vs. Federal Income Tax

State Income Tax vs. Federal Income Tax

Taxes in the United States are governed by a three-tiered system, with different levels of taxation imposed at both state and federal government levels.

Federal and State income taxes can differ in that they apply percentage rates to taxable incomes. However, states may also have different deductions or credits than those for the federal government.

State Income Tax

The question of whether or not you should move to a no-income-tax state can be difficult, but it’s one worth exploring. Fortunately, there are several states without income taxes that could work for your budget and lifestyle needs. 

Of course, this depends on what type of person you are: some people absolutely love living in New Hampshire where they only pay interest income and dividends; others might want more flexibility with their money than just these two types of taxable investment earnings. 

If you’re the kind who likes living somewhere completely different from everyone else around them, then Tennessee is an option as well since it eliminated it is own personal statewide earning tax back in 2021.

The remaining states use a progressive tax system, which taxes residents with higher levels of income at increasingly high rates. As such, the state’s highest earners contribute most to its revenue coffers New York (8.82%), Hawaii (11% on all income over $200K), Wisconsin and North Dakota (7.9%) for incomes above $240k or more; Oregon and California (9%); Colorado has five brackets ranging from 4-6%; South Carolina is 5%, plus 7%.

In most states, higher income is taxed at a greater percentage rate. This means that the highest earners in each state pay more taxes than those with lower incomes to do. States base their tax brackets on federal guidelines but may vary from these depending on how frequently they adjust them to keep pace with inflation or not.

In 2021, Hawaii has the most tax brackets by far at 12. The highest top marginal rate is 13.3% and applies to singles earning over $1 million or married couples with incomes over $1,181,484 per year in California. 

In North Dakota, there are only 2 income tax brackets of which a 3% flat state taxes rates apply for those making more than 433K/year as individuals or 866K/year as a couple filing jointly.

Federal Income Tax

The U.S Internal Revenue Code is the federal income tax rule that underwent significant changes in 2018 with TCJA’s passage into seven marginal tax brackets of 10%, 12%, 22% 24%, 32 %, 35, and 37%.

The 2020 tax year has a top income tier of $518,401 for singles and $622,051 for married couples filing jointly. The 2021 taxable year is slightly different with the top rate kicking in at an additional amount of money to be taxed up to 37%.

Special Considerations

The federal tax system allows taxpayers to claim either a standard deduction or itemize their deductions. The TCJA increased the standard deduction significantly, making it more advantageous for many filers simply to take this option instead of filing under ‘itemized’. 

For 2020, single taxpayer’s can receive $12,400 as a standard deduction while married couples are entitled up to $24,800 in total on one income return.

For the 2021 tax year, there will be an increase in the standard deduction. The new deductions are $12,550 for single taxpayers and those married filing separately; $18,800 head of household/single-parent households; and 25100 dollars per couple filing jointly.

States and the federal government tax different types of income. For example, states do not consider pension or social security as taxable but under federal rules, they are considered taxable. Additionally, income from treasury securities is exempt federally but subject to state taxation.”

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