How Do Taxes Work?

Taxes in the United States can be confusing! Outside the United States, 36 other countries use a return-free filing system, where tax authorities provide pre-filled tax forms to their citizens. Inside the United States, we’re left with a huge list of potential forms to fill out for our federal income taxes. Not to mention a complex system of deductions that can leave us worrying if we’ve paid too much or accidentally paid too little and risk penalties down the line. 

The complexity of the U.S. tax system has led to a large and booming industry of tax service professionals — an estimated $12.6 billion industry in 2022 — that has been growing each year. 

Here's an overview of how the U.S. tax system works, how to understand your federal income tax obligations, and navigate tax season with minimal stress.

How does federal income tax work?

The United States has a progressive federal income tax system, while each state has its own unique state tax system. The federal tax system has tax brackets where each dollar of a taxpayer's taxable income received in that bracket has a different tax rate.

In a progressive system, income received in higher tax brackets is subject to higher income taxes. But the higher tax rate doesn't apply to your income below that tax bracket.

Filing status

First, note that you can file taxes as a single individual, a married couple filing jointly, a married couple filing separately, or as a head of household (unmarried with dependents). The marginal tax brackets change depending on how you file to account for the additional household members. 

Table 1 displays the marginal tax rates for single and married (filing jointly) households for income earned in 2023. 

Tax rates	Single	Married filing jointly
10%	$0-$11,000	$0-$22,000
12%	$11,000-$44,725	$22,000-$89,450
22%	$44,725-$95,375	$89,450-$190,750
24%	$95,375-$182,100	$190,750-$364,200
32%	$182,100-$231,250	$364,200-$462,500
35%	$231,250-$578,125	$462,500-$693,750
37%	$578,125+	$693,750+

Scenario 1: Single individual

George is filing as a single individual and has an adjusted taxable income of $21,000. The first $11,000 of income is taxed at a flat rate of 10%, which comes to $1,100. The last $10,000 of George’s income is in the 12% tax bracket, resulting in $1,200 in taxes. In total, George owed $2,300 in taxes on his $21,000 in earnings. 

Note the progressive aspect: George owed fewer taxes on his first $11,000 than on his next $10,000. If George earned an additional $100, he would owe $12 (12%). That’s the marginal tax rate.  However, George’s average tax rate is 10.95%.  In a progressive tax system, the average tax rate will never be higher than the marginal tax rate. 

Scenario 2: Married filing jointly

Jack and Stacey are married filing jointly. Together, they had $150,000 of taxable income, placing them in the 22% marginal income tax bracket. They owed 10% for the first $22,000, which amounted to $2,200. They owed 12% for the next $67,450 until reaching the $89,450 threshold. That amounted to an additional $8,094 in taxes owed. Finally, they owed 22% taxes on the last $60,550 of income, which came to $13,321. In total, Jack and Stacey owed $23,615 and had an average tax rate of 15.7%. 

Taxable income and tax obligation

In the previous section, we calculated federal income taxes owed based on given income levels. The adjusted income used to determine your taxes may be quite different from your annual salary, so let’s walk through the steps to go from total income to taxable income. 

Step 1: Total income

First, your income received during the year — earned, passive, and portfolio income — is aggregated to calculate your total income.  

Step 2: Adjusted gross income

Second, your income may be adjusted by certain expenses, including educator expenses (if teachers spend their own money on classroom supplies), deductions for a health savings account, and student loan interest deduction. Subtract these from your total income to calculate your adjusted gross income (AGI). 

Step 3: Deductions

Third, calculate your deductions. The 2023 standard deduction — available to everyone — will be $13,850 for single filers and $27,700 for married couples filing jointly. You have the choice to use the standard deduction or to itemize deductions and should use whichever yields the largest deductions.

We’ll go through itemized deductions further below. If you have a small business or are self-employed, you may also be eligible for the qualified business deduction. Subtract these deductions from your AGI in step 2 to get your taxable income. 

Step 4: Taxable income

Next, calculate the tax owed based on your taxable income. This part can get confusing very quickly if you have long-term capital gains, qualified dividends, or recently sold real estate. However, this can be more straightforward if your income is driven by salaries and wages.

If your AGI is less than $100,000 then you can look up tax owed in the tax tables. Here, we can see our first scenario above, where a single individual with $21,000-$21,050 AGI will owe $2,318 in taxes. If you earn more than $100,000 then you must use the tax computation worksheet. 

Step 5: Taxes withheld

If you have W2 income, you’ve likely had tax withheld automatically from each paycheck. Withholding each paycheck minimizes the risk of payment shock where you’d suddenly have to come up with a year’s worth of taxes at the end of the year. If nearly all your income is from your wages, there’s a good chance you’ll get a tax refund. This happens when what you’ve already paid is greater than what you owe. However, if you have very uneven or unreported income (e.g. side hustles, tips), you may or may not have chosen to pay estimated tax amounts during the year. Depending on how accurate your quarterly estimated tax payments are, you may have to pay taxes on top of what you've already provided. 

While not perfect, the IRS offers an online tax calculator. Using this calculator, you can enter information from your recent (or expected future) paychecks including how much you’ve earned and how much you’ve currently withheld to estimate your year-end tax obligation and potential refund from the federal government. 

Taxable income: What’s included?

Your taxable income includes your total income minus any adjustments and deductions. Your total income includes income from this non-exhaustive list of sources:

• Earned income, such as salary, hourly wages, tips, and bonuses
• Passive income, such as royalties, rental income
• Portfolio income, such as dividends and interest
• Losses on earned business income can reduce taxable income

Some sources of income are not included in taxable income including:

• Inheritances
• Gifts (under $17,000)
• Alimony (divorces after 2018) and child support payments
• Welfare payments

Itemized vs. standard deductions

All single filers receive a minimum deduction of $13,850, while married filers receive a minimum deduction of $27,700. However, it is possible to receive a larger deduction if you have paid some of these expenses during the year:

• Mortgage interest on up to two homes
• State and local income tax up to $10,000
• Property taxes
• Medical and dental expenses that exceed 7.5% of your AGI
• Charitable donations

If the sum of your eligible deductions exceeds the standard deduction, then you should itemize. Otherwise, take the standard deduction. 

Tax credits

Tax credits are more powerful than deductions. Deductions reduce your taxable income, of which a share of that is taxed. Tax credits dollar-for-dollar reduce your taxes owed. Some of the most common tax credits include:

• Earned income tax credit: This is limited to low-income workers, with thresholds based on marital status and number of children. The maximum credit is $7,430 for families with at least 3 children, with the maximum AGI of $63,698 if married filing jointly, and having at least 3 children.
• American opportunity tax credit: This provides a credit of up to $2,500 if you paid tuition during the tax year and had modified AGI under $80,000 (single) or $160,000 (married filing jointly). 
• Child tax credit and Dependent care credit: This is a credit of up to $3,000 to defray the costs of childcare for one child or up to $6,000 for two or more children. Families can qualify with income under $200,000 (single) or $400,000 (married filing jointly) modified AGI.

How to file your taxes

The main form driving your tax calculations is Form 1040 and its instructions. These forms look confusing, but note the broad categories on the left of Form 1040 — income, adjustments, deductions, and tax and refund calculations — are precisely what we discussed above. 

Tax calculations can get complicated quickly; however, tax software can simplify it dramatically. If your AGI is less than $73,000, the Internal Revenue Service (IRS) lets you use tax software and file for free.

If you do not qualify for the free services and are not comfortable filling out the 1040 on your own, then you may consider paying for tax preparation software such as TurboTax or H&R Block. These services may ask you guided questions to identify what deductions and adjustments you may qualify for and will automatically calculate your tax owed based on your entries for wages, capital gains, dividends, and more. 

You may also consider hiring a tax professional. The tax professional should file for you and provide you with a copy of all worksheets and forms used in the calculations. You can then review carefully and replicate the filing in future years, making adjustments as necessary if your income sources haven’t meaningfully changed. 

Related: When Are Taxes Due? A 2023 Guide To Filing Deadlines And Extensions

FAQs

Is it possible to earn more but take home less? 

For any one individual or household, earning additional money may push you into a higher marginal tax bracket, but it is highly unlikely that you would ever take home less. This is because the higher marginal tax rate only affects dollars earned above the thresholds. You can confirm this by reviewing the tax tables, noting that taxes owed always increase at higher taxable income. 

One caveat maybe if you’re at the edge of eligibility for a tax credit. In this case, earning a little more might cause you to lose the credit; however, most tax credits are phased out, meaning that how much you’d receive gets smaller as your income nears the threshold.

Some people who earn more may pay less in federal income taxes than someone who earns less, possibly due to aggressive tax deductions or earnings in the form of long-term capital gains. 

Why are bonuses taxed so much? 

Bonuses are considered supplemental income and employers have two ways of withholding taxes for bonuses. First, they may choose a flat withholding rate of 22%. For those of us with an expected average tax rate below 22%, this may be a higher withholding rate than your earlier paychecks.

Second, companies may choose to lump your bonus in with your salary, in which case you’ll have withholding based on your W4 choices. The bonus may push you into a higher marginal tax bracket for that one paycheck, in which case the IRS may withhold a larger share of your paycheck. Note that this is simply withholding; your actual taxes owed on your bonus would be the same as if that income was spread evenly over the year.