Is An Incentive In The Tax Code For Individuals And Corporations To Invest Their Money In Ways

What Are Income Taxes?

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Taxes may not be the most exciting financial topic, but they're definitely important. In the United States, federal and state governments need money to provide certain services and benefits that we wouldn't otherwise have access to, from Social Security payments to local environmental projects. The way these governments obtain that funding is largely by levying taxes on working adults and various business entities.

If you earn money each year, whether that's from working at your job or another source, you'll need to pay income taxes on those funds. But federal and state income tax systems can seem complicated, and you may be curious about what they are, how they work and what they mean for your personal finances. Fortunately, income taxes are relatively straightforward once you have a thorough understanding of the basics.

What Are Income Taxes?

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To better understand income taxes, let's go back to basics. Income is any money you're paid, usually on a regular basis, in exchange for work that you've done or investments that you've made. Taxes are mandatory monetary charges a government collects from individuals to fund that government's spending initiatives. Put them together, and you get income taxes: a percentage of the money you earn that you pay to the government on an annual basis.

Income falls into two different categories — earned income and unearned income. Earned income is income you get in exchange for work that you do. It includes money like your wage or salary and tips. Unearned income is money you receive without working for it or performing a service for it. Examples of unearned income include interest from bank accounts, dividends, profit from investments, inheritance money and alimony payments made to you. You pay taxes on both types of income if you receive them, but their tax rates differ.

State and federal governments use the money they collect in income taxes to finance all of the services necessary to keep their jurisdictions operating and citizens safe. On the state level, this might include municipal services like schools, fire departments, ambulances and police departments. Road work and public parks are other examples of services that state governments finance through income taxes. On the federal level, income taxes support the military and the operation of federal agencies and their divisions. Income taxes also provide funding for a variety of government programs, such as Social Security, WIC and Medicare.

How Do Income Taxes Work?

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Individuals and businesses pay income taxes. When you earn income, you're required to pay a certain percentage of it to the government via the Internal Revenue Service (IRS) — the federal agency that collects taxes and enforces tax laws. The percentage is based on your household's financial situation and on the amount of money you earn over the course of a certain period. In the case of income taxes, that period is a calendar year.

Each year, the IRS publishes tax brackets that establish what percentage of income you owe in federal taxes. The tax brackets are divided by filing status. Married people, single people and heads of households all have their own tax bracket tables. Tax brackets are a progressive system — meaning the lower a person's income is, the lower their tax rate is — and each bracket percentage has a range of values.

Most people don't have a single income tax rate. That's because different brackets have different tax rates, and you only pay a bracket's rate on the amount of your income that falls within that bracket. Here's an example to illustrate how this works. Imagine that there are three tax brackets, each with its own rate (keep in mind these numbers don't represent actual federal rates and are vastly simplified):

$0–$20,000 in income has a 5% tax rate
$20,001–$60,000 in income has a 10% tax rate
$60,001 and above has a 15% tax rate

Based on this example, if you earned $15,000 in a year, you'd only pay 5% in income taxes. If you earned $30,000, however, you'd pay 5% in taxes on your earnings up to $20,000 and 10% in taxes on $9,999, which is the difference between $30,000 and $20,001. If you earned $80,000, you'd pay 5% in income taxes on your earnings up to $20,000, 10% in income taxes on the $39,999 you earned that falls into the $20,001–$60,000 bracket, and 15% on the $19,999 you earned above $60,000.

Many people think of the annual state and federal taxes they file as income taxes — that's why the annual tax filing due April 15 each year is called an income tax return. But taxpayers pay income taxes more than one time per year, and certain types of earners file taxes multiple times a year. Earned income is taxed on every paycheck. Self-employed people pay taxes both quarterly and annually. Businesses pay income taxes annually.

What's the Role of Withholdings on Income Taxes?

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In regards to earned income, as we mentioned, part of every paycheck you get throughout the year goes toward income taxes. The amount that's taken out of your check before you get paid is called a withholding, and its purpose is to cover your income taxes incrementally throughout the year so you don't need to pay a lump sum when your tax filing is due.

Generally, companies process these income tax deductions for their employees, and independent contractors are responsible for paying their own income taxes because they're considered their own employers for tax purposes. The amounts of these deductions are based on a combination of the law, the W-4 form you submitted to your employer and any other state withholding forms that apply.

The W-4 and similar state forms are called withholding forms because they determine how much income tax will be withheld from every paycheck. The selections you make when you fill out the form determine your filing status (such as married filing jointly, married filing separately, single or head of household), and there are calculations to account for additional deductions based on the number of dependents you have.

For a variety of reasons, some people choose to withhold more income tax per paycheck than is necessary. The income taxes you pay after the end of the calendar year are a reconciliation between you and the state or federal government. This is when you pay taxes based on your actual earnings, filing status and number of dependents, even if you've chosen to declare different information on your withholding forms. If you have extra money withheld over and above what you actually owe, the IRS will refund it to you. If you didn't have enough money withheld, perhaps because you wanted larger paychecks throughout the year, you could owe the IRS money upon filing.

What's the Difference Between State and Federal Income Taxes?

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With few exceptions, the process of filing and paying state and federal income taxes works the same way. The difference lies in who has to pay and how much they pay. The federal government levies an income tax on all people who earn income throughout the country, and it uses the same standardized tax bracket system, which can change annually, for all taxpayers. In contrast, states don't always levy income taxes, and they don't always use brackets. Some states have a flat income tax rate, so all payers pay the same percentage regardless of how much they make. Other states don't have income taxes at all.