Income tax basics

While U.S. income tax law is very complex, the underlying idea is relatively easy to understand. Simplifying greatly, gross income is all income from all sources (§ 61) less any exclusions (§ 101 et seq.). An exclusion is something that Congress has effectively said a taxpayer need not include in his or her income for tax purposes, such as employer-paid health insurance (§ 106) or interest from tax-exempt bonds (§ 103).

For individuals, Adjusted Gross Income (AGI) is gross income less any above-the-line deductions (§ 62). Above-the-line deductions are listed in § 62 and include trade or business deductions, alimony (§ 215), and moving expenses (§ 217). Taxable income is AGI less (1) itemized deductions or the applicable standard deduction, whichever is greater, and (2) a deduction for any allowable personal exemptions for the taxpayer, the taxpayer's spouse (if filing jointly), and the taxpayer's dependents. (In certain cases involving higher income taxpayers, the allowed personal exemptions may be reduced or even eliminated.)

Non-itemizers take the standard deduction. Itemized deductions include any deduction not listed in § 62 such as charitable contributions (§ 170) and certain medical expenses (§ 213). Taxable income is then multiplied by the appropriate tax rate to arrive at the tax due. Tax credits such as the Earned Income Tax Credit (§ 32) or the Child Tax Credit (§ 24) lower the tax owed on a dollar-for-dollar basis. This means tax credits are more valuable than deductions, because deductions are applied before the tax rate, while credits are applied after. For instance, with a 35% tax rate, a deduction of $100 would save only $35 of taxes, while a $100 credit would save $100 worth of taxes.

Types of income

For tax purposes, income can be divided in a variety of ways. The first division is between ordinary income and capital gains. Ordinary income includes compensation for personal services such as wages and salaries, business profit, dividends from stock shares, and interest income from invested funds while capital gain generally comes from the sale of investment property. Congress has typically shown a preference for long-term investment by having a capital gains tax rate lower than the ordinary income rate. However, only long-term capital gains get preferential treatment; short-term capital gains (from property held for one year or less) are taxed at the same rate as ordinary income. Added complications come from various distinctions within each category.

For instance, qualified dividends, which were previously taxed at ordinary income rates (as non-qualified dividends currently are), are currently taxed at long-term capital gain rates until 2011 under the Jobs and Growth Tax Relief Reconciliation Act of 2003, and within long-term capital gains, gains on certain real estate, collectibles, and small business stock each have their own tax rates. The rules for offsetting capital losses with gains (whether capital or ordinary) add further complications. In ordinary usage, when someone speaks of their "tax rate", they typically are referring to their marginal tax rate for ordinary income.

Another important distinction in types of income is income from passive activities versus non-passive activities (§ 469), an attempt to curb tax shelters used by taxpayers not directly involved with an activity other than as an investor ("passive")

Year 2008 income brackets and tax rates

Year 2009 income brackets and tax rates

Effective income tax rate in 2008 as function of taxable income. The two most common filing statuses are shown, single (black curve) and married filing jointly (red curve). The dashed green line represents the maximum tax rate. This graph should not be interpreted as bearing on the so-called marriage penalty.

An individual's marginal income tax bracket depends upon his income and his tax-filing classification. As of 2008, there are six tax brackets for ordinary income (ranging from 10% to 35%) and four classifications: single, married filing jointly (or qualified widow or widower), married filing separately, and head of household.

An individual pays tax at a given bracket only for each dollar within that bracket's range. For example, a single taxpayer who earned $10,000 in 2009 would be taxed 10% of each dollar earned from the 1st dollar to the 8,350th dollar (10% × $8,350 = $835.00), then 15% of each dollar earned from the 8,351th dollar to the 10,000th dollar (15% × $1,650 = $247.50), for a total of $1,082.50. Notice this amount ($1,082.50) is lower than if the individual had been taxed at 15% on the full $10,000 (for a tax of $1,500). This is because the individual's marginal rate (the percentage tax on the last dollar earned, here 15%) has no effect on the income taxed at a lower bracket (here the first $8,350 of income taxed at 10%). This ensures that every rise in a person's pre-tax salary results in an increase of his after-tax salary.

However, taxpayers are not taxed on every dollar they make. For 2009, single and married filing separate taxpayers are allowed a standard deduction of $5,700. Married filing jointly and surviving widow(er)s are allowed $11,340 and head of household taxpayers are allowed $8,350. Taxpayers over 65 or blind are given an additional $1,100 standard deduction ($2,200 if over 65 and blind). A taxpayer may choose to take the standard deduction or they may itemize their deductions if the amount of itemized deductions is greater than the standard deduction.

Taxpayers are also allowed a personal exemption depending on their filing status. The personal exemption amount in 2009 is $3,650 per person.

Claiming deductions may reduce an individual's tax liability by a rate equal to the marginal tax rate of their particular tax bracket, with a corresponding reduction in returns as the individual crosses in to a lower tax bracket. For example, if an individual is able to increase the amount of their deduction by $1000 with a last-minute donation to a charitable organization, and the individual's adjusted gross income is $500 into the 25% marginal tax bracket, the donation will reduce the tax liability of the individual by ($500 × 25%) + ($500 × 15%) = $200.

The effective tax rates corresponding to the definitions above are shown in the accompanying graph.

Short-term capital gains are taxed as ordinary income rates as listed above. Long-term capital gains have lower rates corresponding to an individual’s marginal ordinary income tax rate, with special rates for a variety of capital goods.

Capital gains up to $250,000 ($500,000 if filed jointly) on real estate used as primary residence are exempt.