The knowledge of how income tax is calculated and reduced is one area of financial education that everyone would love to have. Out of the increasing need for this request from people overburdened with high tax issues, I have decided to put this write-up together. Let’s start with a proper understanding of income tax and how it works.
Income Tax
This refers to a type of tax imposed by governments on the income generated by businesses and individuals within their jurisdiction.
Governments generate revenue from income taxes. They are used for purposes like paying for government obligations, funding public services, and providing goods to citizens. Many states and local governments, in addition to the federal government, levy income taxes.
In some cases, certain investments, such as housing authority bonds, are exempt from such taxes. A financial advisor can assist you in developing the best tax strategy for your specific financial needs and goals.
History of U.S Income Tax
On August 5, 1861, the United States imposed the first personal income tax to help fund its war effort in the American Civil War (3% of all incomes over US$800) (equivalent to $19,300 in 2021).
In 1862, this tax was repealed and replaced by another income tax. The first peacetime tax, the Wilson-Gorman tariff, was enacted only in 1894. The rate was 2% on income over $4000 (equivalent to $115,000 in 2021), so less than 10% of households would pay anything.
This income tax was designed to compensate for revenue lost due to tariff reductions. The tax was declared unconstitutional by the US Supreme Court, citing the 10th amendment’s prohibition on any powers not expressly granted to the states.
This tax became a permanent fixture in the United States tax system with the adoption of the Sixteenth Amendment to the United States Constitution in 1913.
Annual internal revenue collections surpassed the billion-dollar mark for the first time in fiscal year 1918, rising to $5.4 billion by 1920. The amount of income tax collected has varied dramatically, from 1% in the early days of US income tax to taxation rates of more than 90% during WWII.
How Does Income Tax Work?
The Internal Revenue Service (IRS) is responsible for tax collection and tax law enforcement in the United States. The IRS has a complex set of rules and regulations governing reportable and taxable income, deductions, and credits, among other things.
The agency is in charge of collecting taxes on all types of income, including wages, salaries, commissions, investments, and business earnings.
Personal income taxes collected by the government can be used to fund government programs and services such as Social Security, national security, education, and roads.
Types of Income Tax
The different types of income taxes are;
Individual Income Tax
This is another term for personal income tax. This type of income tax is levied on wages, salaries, and other forms of income. This tax is imposed by the state. Due to exemptions, deductions, and credits, the majority of people do not pay taxes on all of their income.
Business Income Tax
Businesses must also pay income taxes on their earnings; the IRS taxes corporate, partnership, self-employed contractor, and small business income.
The corporation, its owners, or shareholders report their business income and then deduct there own operating and capital expenses, depending on the business structure. In general, their taxable business income is the distinction to be made between their business income and their operating and capital expenses.
State and Local Income Tax
Personal income taxes are also levied in the majority of US states. Personal income taxes are not levied in the following states: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming.
How Income Tax is Calculated
Calculating your own income tax should not be complicated. If you do not have a very haphazard and complicated tax situation, you can always use a tax calculator to know your income tax.
However, to calculate this type of tax, add up all sources of taxable income earned during the tax year. The following step is to compute your adjusted gross income (AGI). After that, subtract from your AGI any deductions for which you are eligible.
What Percentage of Income is Taxed?
The percentage of your income that is taxed is determined by your earnings and filing status. Theoretically, the more you earn, the more you must pay. The federal income tax rate varies between 10% and 37%.
Strategies to Reduce Taxes on Your Income
It is very difficult to avoid taxes. However, there are various ways you can ward them off. Some of them are written below;
Start a Business
Side businesses offer tax advantages. These advantages includes deducting health insurance premiums, home office expenses, and utilities and Internet cost from income. Therefore reducing the total tax obligation.
To claim these deductions, taxpayers must make a profit in three to five years conducting a business. The SECURE Act offers tax incentives to employers who offer retirement options.
Invest in Municipal Bonds
Purchasing a municipal bond entails lending money to a state or local governmental entity in exchange for a set number of interest payments over a set period of time. When the bond matures, the buyer receives the full amount of their initial investment back.
Municipal funds are tax-free at the federal level. Depending on where you live, it may also be tax-free at the state and local levels. Municipal bonds are appealing to investors because the interest payments are tax-free.
Go for Long Term Capital Gains
Investing can be a useful tool for increasing wealth. The favorable tax treatment for long-term capital gains is another advantage of investing in stocks, mutual funds, bonds, and real estate.
If an investor holds a capital asset for more than a year, the capital gain is taxed at a preferential rate of 0%, 15%, or 20%. This depends on the investor’s income level. However, this is not the case if it is held for less than a year.
Understanding long-term versus short-term capital gains rates is critical for wealth accumulation.
Take Advantage of Tax Credits
The Earned Income Tax Credit is one of many IRS tax credits that reduce taxes. For the tax year 2023, a low-income taxpayer could claim credits of up to $7,430 if they have three or more qualifying children. They can also claim $6,604 if they have two, $3,995 if they have one, and $600 if they have none. These figures have risen from $6,935 for three or more children, $6,164 for two, $3,733 for one, and $560 in 2022.
Max Out Your Retirement Accounts and Employee Benefits
Contributions to 401(k) or 403(b) plans can reduce taxable income up to $22,500 in 2023 (from $20,500 in 2022). Those aged 50 and above can increase their basic workplace retirement plan contribution to $7,500 ( from $6,500 in 2022). For example, if an employee earns $100,000 in 2023 and contributes $22,500 to a 401(k), their taxable income is reduced to $77,500.
Make Use of Health Savings Account (HSA)
Employees having a high-deductible health insurance plan can use a health savings account (HSA) to save money on their taxes. As with a 401(k), payroll HSA contributions are excluded from the employee’s taxable income. Direct contributions to an HSA are 100% tax-deductible from income.
Conclusion
Your income tax can be controlled if you have some of these things in place. You can also pay very little in taxes in the United states. It is possible.
