One of the most common questions we get is, “What income is taxed, and how?” It’s a great question and one that has a lot of nuance to it. So, in this article, we’ll break down the types of income that are taxable and provide an overview of how the tax process works.
First things first: what is taxable income? Put simply, taxable income is any money that you earn that is subject to federal, state, and local income taxes. This includes:
- Wages and salaries: If you’re employed by a company, any money you earn from that job is considered taxable income. This includes bonuses and commissions.
- Self-employment income: If you work for yourself as a freelancer, contractor, or business owner, any money you earn from those endeavors is also considered taxable income.
- Investment income: Any money you earn from investments, such as stocks, bonds, and mutual funds, is taxable. This includes dividends, interest, and capital gains.
- Retirement income: Income from retirement accounts like 401(k)s and IRAs is taxable, as are distributions from pension plans.
- Rental income: If you earn money from renting out a property, that income is taxable.
- Miscellaneous income: This includes income from sources like alimony, gambling winnings, and unemployment benefits.
Now that we know what income is taxable, let’s talk about how it gets taxed. The US tax system is a progressive system, which means that the more money you make, the higher your tax rate. The system is divided into tax brackets, which are groups of income levels that are taxed at different rates. Here are the 2022 federal tax brackets for single filers:
- 10% on taxable income from $0 to $10,275
- 12% on taxable income from $10,276 to $42,900
- 22% on taxable income from $42,901 to $91,150
- 24% on taxable income from $91,151 to $165,000
- 32% on taxable income from $165,001 to $315,000
- 35% on taxable income from $315,001 to $400,000
- 37% on taxable income over $400,000
So, let’s say you’re a single filer with a taxable income of $50,000. The first $10,275 of that income is taxed at a rate of 10%, which comes out to $1,028. The next $32,625 is taxed at a rate of 12%, which comes out to $3,915. Finally, the remaining $7,100 is taxed at a rate of 22%, which comes out to $1,562. In total, you would owe $6,505 in federal income taxes.
Of course, the federal tax system is just one piece of the puzzle. Depending on where you live, you may also owe state and local income taxes. These taxes work in a similar way to federal taxes, with different tax brackets and rates based on your income. For example, in California, the state income tax system has nine brackets, with rates ranging from 1% to 13.3%.
It’s worth noting that not all income is taxed equally. Some types of income are taxed at a lower rate or not at all. Here are a few examples:
- Long-term capital gains: If you hold an investment for more than a year before selling it, any profit you make is considered a long-term capital gain. These gains are taxed at a lower rate than ordinary income, with rates ranging from 0% to 20% depending on your income level.
- Qualified dividends: Some dividends are considered “qualified” and are taxed at the same lower rate as long-term capital gains. To be considered qualified, the dividends must be paid by a US corporation or a qualified foreign corporation and meet certain other criteria.
- Municipal bond interest: If you invest in bonds issued by state or local governments, the interest you earn on those bonds is generally not subject to federal income tax. This can make municipal bonds an attractive option for investors looking to minimize their tax liability.
It’s also worth noting that there are various deductions and credits available that can reduce your taxable income or lower your tax bill. Here are a few examples:
- Standard deduction: This is a set amount of money that you can deduct from your taxable income based on your filing status (single, married filing jointly, etc.). For 2022, the standard deduction for single filers is $12,950, while the standard deduction for married filing jointly is $25,900.
- Itemized deductions: In some cases, you may be able to deduct certain expenses from your taxable income, such as charitable donations, mortgage interest, and state and local taxes. You can choose to take the standard deduction or itemize your deductions, whichever results in a lower tax bill.
- Tax credits: These are dollar-for-dollar reductions in your tax bill. Some common tax credits include the Earned Income Tax Credit (EITC), the Child Tax Credit, and the American Opportunity Tax Credit (AOTC).
So, that’s a brief overview of what income is taxed and how. Of course, the tax system is much more complex than we can cover in a single article, and many factors can impact your tax liability. Here are a few additional tips to keep in mind:
- Keep good records: It’s important to keep track of all your income and expenses throughout the year so that you can accurately report your taxable income come tax time.
- Consider working with a tax professional: If your tax situation is particularly complex, or if you’re unsure of how to navigate the tax system, it may be worth working with a tax professional. A qualified tax preparer can help ensure that you’re taking advantage of all the deductions and credits available to you and can help you avoid costly mistakes.
- Stay up-to-date on tax law changes: The tax code is constantly evolving, and it’s important to stay informed about any changes that could impact your tax liability. This is especially important if you’re self-employed or have a unique tax situation.
In conclusion
Understanding what income is taxable and how it gets taxed is an important part of being a responsible taxpayer. By staying informed and keeping good records, you can help ensure that you’re paying the right amount of taxes and taking advantage of all the deductions and credits available to you. And if you’re ever unsure about how to navigate the tax system, don’t hesitate to reach out to a tax professional for guidance.
It’s also important to note that while paying taxes may not be the most enjoyable task, it’s a necessary part of contributing to the functioning of our society. Taxes fund important programs and services like education, healthcare, and infrastructure, and by paying our fair share, we’re helping to build a better future for ourselves and our communities.
In summary, here’s a quick recap of what we’ve covered:
- Most types of income are taxable, including wages, salaries, tips, and self-employment income.
- Certain types of income, such as investment income and rental income, are also subject to taxation.
- There are various deductions and credits available that can reduce your taxable income or lower your tax bill, including the standard deduction, itemized deductions, and tax credits.
- It’s important to keep good records, stay up-to-date on tax law changes, and consider working with a tax professional if your tax situation is complex.
By understanding what income is taxable and how it’s taxed, you can help ensure that you’re fulfilling your tax obligations while minimizing your tax liability. So whether you’re a seasoned taxpayer or just starting, it’s always a good idea to stay informed and educated about the tax system.
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