How Income Taxes Work

In this topic, you'll learn:

• Exploring the types of income.
• How taxable income is determined.
• The effects of tax brackets on income taxes owed.

---

Federal income tax is a tax levied by the federal government on the income earned by individuals. In fact, over half of the federal government's revenue comes from income taxes. In addition to federal income taxes, workers in all but seven states also pay a separate income tax to their state. 

Income taxes are paid as income is earned throughout the year - typically through employer withholding, where a portion of each paycheck is deducted and sent to the government. Employer withholding also includes Social Security and Medicare taxes. So, altogether, income and income-related taxes comprise over 85% of federal government revenue. 

Those who are self-employed or have other sources of income may not be subject to employer withholding. Still, they do pay the same taxes through quarterly estimated tax payments.

The Types of Income

The federal income tax system is progressive, meaning the tax rate increases as income increases. State income taxes may be progressive, or they may be taxed at a flat rate. But what exactly is considered income?

When it comes to taxes, there are two types of income - "earned" income and "unearned" income. First, earned income is income that is earned through work, including:

• Wages and salaries
• Tips and bonuses
• Commissions
• Self-employment income

In addition to income tax, earned income is subject to Social Security and Medicare taxes - an additional 15.3% tax on earned income (though employers pay half of those taxes, and Social Security tax only applies up to a certain income threshold each year).

On the other hand, unearned income is income that is not earned through work, including:

• Interest and dividends 
• Rental income 
• Capital gains from the sale of assets
• Pension benefits and some types of retirement income
• Social Security benefits (depending on the recipient's income level)

Unearned income is typically subject to federal and state income taxes, but not Social Security and Medicare taxes - potentially resulting in lower taxes for some taxpayers, depending on their income level and tax situation.

In addition, capital gains are a special type of unearned income related to returns on certain investments (like stocks) that are held for a year or longer. They're taxed much lower than regular income - as low as 0% for lower-income taxpayers and up to 23.8% for high earners (including a 3.8% Net Investment Income Tax). If you've ever heard billionaire Warren Buffet claim that he pays a lower tax rate than his secretary, this difference is exactly what he's talking about. 

When "Income" Becomes "Taxable Income"

Whether your income is earned or unearned, you won't pay federal taxes on all of it because of tax deductions. Tax deductions are expenses that can be subtracted from your total taxable income, reducing the income subject to tax. Only after subtracting all deductions does your income become taxable by the federal government.

Examples of common tax deductions include:

• Standard deduction - A flat amount taxpayers can deduct from their income to reduce their taxable income. The standard deduction amount varies depending on the taxpayer's filing status.

• Home mortgage interest - Taxpayers who own a home and have a mortgage can deduct the interest they pay each year.

• Retirement contributions - Contributions to qualified retirement accounts, such as a 401(k) or IRA, can be deducted up to certain limits.

• Student loan interest - Up to $2,500 can be deducted per year, per household.

• Heath savings account contributions - For those with high-deductible health insurance plans, up to $4,400 per individual or $8,750 per couple can be deducted for the 2026 tax year. An additional $1,000 is deductible for those who are 55 or older.

• Business expenses - Self-employed taxpayers can deduct expenses related to running their business, such as office rent, equipment, and supplies.

All taxpayers can take the "standard deduction," which is $16,100 for single filers and $32,200 for joint filers in 2026 (the exact deduction varies yearly). For example, if a couple filing jointly earns $100,000 and chooses to take the standard deduction, their income subject to federal income tax would be just $67,800. Other deductions could potentially lower taxable income as well.

On the other hand, you can choose not to take the standard deduction and, instead, itemize tax deductions. When deductions are itemized, other expenses also become deductible, such as mortgage interest, charitable contributions, state and local income, sales, and property taxes, and certain losses from investments, gambling, and federally declared disasters (subject to limits). However, itemizing deductions yields a lower deduction than the standard deduction for most taxpayers. As a result, around 90% of all taxpayers have taken the standard deduction in recent years.

In addition to deductions, federal tax credits are available to some taxpayers. Tax credits reduce the amount of taxes owed on a dollar-for-dollar basis. Some common tax credits include the child tax credit, earned income tax credit, and education tax credits. Note that eligibility for certain credits does vary with income. The child tax credit, for example, begins to be phased out for couples filing jointly with a modified adjusted gross income of $400,000 or more.

How Tax Brackets Work

Once taxable income is established by subtracting any deductions from your income, the Internal Revenue Service uses tax brackets to determine the amount of federal income tax owed. The IRS uses a progressive tax system, which means that as your income increases, the tax rate you pay also increases. States that levy income taxes may use a progressive or flat-rate method to calculate applicable taxes.

Income tax brackets are a set of income ranges used to determine the amount of federal income tax owed. Each income range corresponds to a tax rate, and as your income increases, you move into a higher tax bracket with a higher tax rate. Seven federal income tax brackets range from 10% of taxable income to 37%. State tax rates vary depending on the state.

The tax brackets that apply to your income also depend on your filing status: single, married filing jointly, married filing separately, or head of household. For example, unmarried singles progress through the brackets faster than married couples who file their taxes together. 

Here's an example of how tax brackets work:

A married couple filing jointly with an income of $100,000 for the tax year 2025 that claims the standard deduction of $31,500 would have a taxable income of $68,500 (excluding any other deductions). Based on the federal income tax brackets, they would pay:

• 10% on the first $24,800 of taxable income, which is $2,480
• 12% on taxable income over $24,801 and up to $100,800 (in their case $68,500 - $24,800 = $43,700), which is $5,244

The total federal taxes owed would be just $7,724. As you can see, moving to a new bracket applies only to income in that bracket - not overall income.

So, how could this couple reduce their tax bill? If they contributed $10,000 to a qualified retirement savings plan, their taxable income would drop to $58,500. If they also contributed $8,750 to a health savings account, their taxable income would drop to $50,750 - dropping their tax bill to $5,594. 

In addition, some taxpayers may be eligible for various tax credits that can further reduce their tax liability on a dollar-for-dollar basis. For example, if our hypothetical couple earning $100,000 had two children under 17, they would get a credit (not deduction) of $2,200 per child - bringing their total federal tax bill to just over $1,000.

The Takeaway

We've touched on how income taxes work, but there's much more to learn. And above all, if you need more information about your unique tax situation, please consult a qualified professional.