2025 Guide: Understanding Income Tax Types and How They Are Calculated with Updated Rates

Julia Kagan is a financial and consumer journalist, formerly senior editor of personal finance at ZAMONA.

What Is Income Tax?

Income tax is a mandatory payment imposed by governments on the earnings generated by individuals and businesses within their territories. It requires taxpayers to file an annual return to assess their tax liability.

These taxes serve as vital government revenue streams, funding essential public services and infrastructure. Besides the federal government, most U.S. states and local authorities also levy income taxes.

Certain investment types, such as housing authority bonds, may benefit from tax exemptions under specific conditions.

Key Insights

• Income tax applies to earnings of individuals and businesses within government jurisdiction.
• Collected taxes support public services, government obligations, and community goods.
• Federal, state, and local governments often have separate income tax systems.
• Personal income tax targets wages, salaries, and other individual income sources.
• Business income tax affects corporations, partnerships, small businesses, and the self-employed.

How Income Tax Functions

In the U.S., the Internal Revenue Service (IRS) administers tax collection and enforcement, using detailed regulations to define taxable income, deductions, and credits. Taxable income includes wages, salaries, commissions, investments, and business profits.

Revenue raised through income taxes finances vital programs such as Social Security, national defense, education, and transportation infrastructure.

Income Tax History

The first U.S. income tax was introduced in 1862 to fund the Civil War, repealed post-war, and reinstated in 1913 with the Revenue Act. The same year saw the introduction of IRS Form 1040.

Most countries, including the U.S., utilize a progressive tax system where tax rates increase with income. For 2023 and 2024, federal rates range from 10% to 37%.

Types of Income Tax

Individual Income Tax

Also known as personal income tax, this tax applies to individuals' wages, salaries, and other income. Deductions, exemptions, and credits often reduce taxable income, lowering the overall tax owed.

The IRS provides various deductions and credits, such as those for healthcare costs, investments, and education expenses. For example, a $100,000 income with $20,000 in deductions results in a taxable income of $80,000.

Tax credits directly decrease the tax owed, benefiting primarily middle- and lower-income households. For instance, a $20,000 tax bill reduced by $4,500 in credits results in a $15,500 tax liability.

Important

Taxable income equals adjusted gross income (AGI) minus allowable deductions, either standard or itemized.

Business Income Tax

Businesses, including corporations, partnerships, and self-employed individuals, pay income tax on profits after deducting operating and capital expenses. The taxable business income is the difference between gross income and allowable expenses.

State and Local Income Tax

Nine U.S. states do not impose personal income taxes: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

However, states without income taxes often compensate through higher sales taxes or fewer public services. Additional factors such as healthcare costs and job availability also affect affordability.

For example, Florida charges a 6% sales tax, while Tennessee’s sales tax is 7%.

Note

For uncomplicated tax situations, online tax calculators can estimate income tax liabilities.

State tax laws frequently change, making future tax burdens difficult to predict.

What Percentage of Income Is Taxed?

The tax percentage depends on income level and filing status, with federal rates spanning from 10% to 37% in a progressive structure.

How to Calculate Income Tax

Calculate total taxable income for the year, determine your AGI, then subtract eligible deductions to find your taxable income.

States Without Income Tax

States exempt from personal income tax include Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

The Bottom Line

Federal income tax applies to all taxpayers, with additional state and local taxes depending on residency. The progressive tax system ensures higher earners pay more, though exemptions and deductions reduce overall tax burden for most individuals.

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