As the old adage goes, taxes are one of the only certainties in life. Following is an introduction to individual income tax -- including how taxable income is determined and the legal obligation of most citizens to pay income taxes to both the federal and state government. See Personal Income Tax: Overview and The IRS and Your Rights for more details.
The federal income tax is the largest source of funds used to finance federal government expenditures. Besides raising revenue, the individual income tax serves a social function by allocating resources, subsidizing some persons or activities, encouraging certain kinds of economic and social behavior, redistributing wealth, stimulating economic growth, and addressing specific social problems such as pollution and urban decay. Although the federal income tax applies to most revenue producing entities including all U.S. citizens and residents, corporations, trusts, and estates, this section is focused on individual income taxation. The tax is a progressive tax -- with the percentage of tax increasing as the net taxable income of a taxpayer increases.
Individuals are required to file federal returns if their gross income exceeds a stated threshold. The threshold varies based on the age of the individual, marital status, and residency status. Gross income is defined as all income from whatever source derived. Most income is taxable unless specifically excluded from gross income by the Tax Code -- including compensation, interest, dividends, gains on the sale of assets, net rental income, net business income, income from partnerships, trusts or estates, forgiveness of indebtedness, gambling winnings, court awards or damages, alimony, and miscellaneous payments for services of any kind.
"Adjusted" Gross Income
Once gross or total income is calculated, certain adjustments are applied to determine adjusted gross income. Common adjustments include eligible retirement account contributions, student loan interest, medical saving account contributions, qualified moving expenses, self-employment tax, early withdrawal penalties, and alimony paid. Adjustment amounts are deducted from total income to determine adjusted gross income.
Deductions and Exemptions
Adjusted gross income is further reduced by either the standard deduction or itemized deductions and by personal exemption amounts. The standard deduction amount varies depending on the taxpayer's filing status.
Itemized deductions are deducted from adjusted gross income to determine the net income subject to tax. The most common itemized deductions are state and local income taxes, real property taxes, personal property taxes, home mortgage interest, investment interest, and charitable contributions. Certain itemized deductions such as medical expenses, casualty losses, employee business expenses, and miscellaneous deductions are deductible only to the extent that they exceed a certain percentage of adjusted gross income.
Taxpayers are also able to claim a personal exemption amount for the taxpayer plus a like amount for a spouse and each dependent child if applicable. Taxpayers can claim other relatives as dependents in certain limited circumstances. Itemized deductions and personal exemption amounts are phased out for higher income taxpayers.
Determining Taxable Income
The personal exemption amount plus itemized deductions are netted against adjusted gross income to derive the taxable income amount. Tax tables or tax rate schedules are applied to the taxable income amount to calculate the amount of tax due. Once the tax is computed, certain credits may apply that will reduce the amount of tax due dollar for dollar. Typical credits include childcare credits, dependent care credits, foreign tax credits, credit for the elderly, education credits, earned income credits, and adoption credits.
There are additional taxes that may apply to your individual income tax bill, such as self-employment taxes, household employment taxes, tax on early distributions from retirement plans, and the alternative minimum tax. The most prevalent of these is the alternative minimum tax. The alternative minimum tax applies when a taxpayer's alternative tax exceeds the regular tax. Taxpayers are required to recompute their tax based on an alternative system which requires the taxpayer to add back itemized deductions and certain favorable tax preference items to make sure the taxpayer is paying a minimal amount of tax. The alternative minimum tax is similar to a flat tax to the extent it is a tax on total income with limited adjustments.
Special favorable rules apply to capital gains. Long-term capital gains depend on the taxpayer's tax bracket. In order to qualify, the asset sold must be a capital asset held for more than a year. A capital asset is defined to include everything owned for personal or investment purposes, including such items as stocks and bonds, a house, household goods, a car, and other personal property. If a taxpayer has a loss on the sale of a capital asset, the taxpayer can net the loss against any capital gains.
When to File Individual Income Tax Returns
Individual income tax returns are due on April 15 in the year subsequent to the tax year. Although taxpayers can file for an extension to file their return until as late as October 15, the taxes are due by April 15. The Internal Revenue Service can impose penalties and interest for failure to pay the taxes due by April 15 or failure to file by the due date (April 15 or the extended date.)
Most states also collect individual income tax. Taxpayers are potentially subject to state income tax in their state of residence and in any state where a taxpayer works or owns real property. Many states determine a citizen's taxable income in a manner that is similar to that used by the federal government (and discussed above).