Here’s a quick overview of the U.S. federal income tax.
Table of Contents
Even if you rely on a tax professional, or use software to prepare your tax return, a general understanding of how income tax is calculated can be useful.
Four Steps
Figuring your income tax involves four steps:
- Find your total income.
- Subtract your deductions: the result is your taxable income.
- Apply the tax rates to find your tax.
- Subtract your withholding and other payments and credits: the result is the tax you owe, or the refund you have coming.
Step 1: Total Income
Total income includes many kinds of receipts: wages, interest, dividends, business and partnership income, amounts you receive from IRAs and pension plans, lottery winnings — and the list goes on. Of special interest: it includes your profit from sales of assets such as stock or real property — in other words, capital gain. But some items aren’t included. For example, total income doesn’t include gifts you receive or life insurance proceeds.
Step 2: Deductions
Deductions come in four main flavors:
Business deductions
These deductions are claimed as part of the calculation of business income, so they’re actually part of the determination of total income in Step One. But take note: deductions related to your investment activities are not considered business deductions.
Adjustments
These are deductions you’re allowed to claim even if you don’t claim itemized deductions (see below). For example, your contributions to an IRA or Keogh plan fall into this category. When you subtract your adjustments from total income, you arrive at an important number called adjusted gross income.
Itemized deductions; standard deduction
Each year you’re allowed to claim itemized deductions or the standard deduction, whichever is larger. Itemized deductions include such items as medical expenses, state and local taxes, mortgage interest and charitable contributions. If those items don’t add up to a large enough total, you claim the standard deduction instead. Your standard deduction depends on your filing status and is adjusted each year for inflation. Most people find that the standard deduction is larger than the total of their itemized deductions, especially since the rules changed in 2018 to enhance the standard deduction and limit what you can itemize. Yet itemizing still makes sense for some taxpayers, especially at higher income levels.
For a single filer in 2022 (not blind or over age 65) the standard deduction is $12,950. Figures like this appear in our Reference Room
Exemptions
A 2017 law temporarily repealed the deduction for personal and dependency exemptions for tax years 2018 through 2025. It remains to be seen whether Congress will permit this deduction to be restored, or perhaps make its repeal permanent.
Taxable income
When you’ve subtracted all of these deductions from your total income, the result is your taxable income.
Step 3: Apply the Tax Rates
Once you know your taxable income, you apply the tax rates to find out your tax. If your income includes long-term capital gain, a special calculation provides the benefit of lower rates that apply to this type of income.
Step 4: Subtract Payments and Credits
The tax law allows you to claim certain credits that reduce the amount of tax you owe. For example, taxpayers with children may be able to claim a child credit. And of course, you get credit for any tax you’ve already paid — including income tax your employer withheld from your paycheck and any estimated tax payments you made during the year. Subtract your credits and payments from your tax to find out how much you owe. If your payments exceed the tax, you’re in luck: you have a refund coming!
Remember: A deduction reduces your taxable income; a credit directly reduces your tax.