This post explains at a high level how taxation in the US works. This article only talks about federal taxes, not state taxes.
Income
There are 2 types of income
- Earned income, e.g.
- salary, wages and compensation
- appreciated assets that have been sold during the tax year
- Unearned income, e.g.
- canceled debts,
- government benefits (such as unemployment benefits and disability payments),
- strike benefits,
- lottery payments,
- interest,
- dividends,
- rents,
- capital gains
Filing Status
When you file your taxes, you can choose from one of the following, depending on your situation:
- single
- head of household
- married filing jointly
- married filing separately
Ordinary Income Tax Rates By Income (2023)
Filing status = single
| Income | Marginal Tax Rate / Bracket |
|---|---|
| Up to $11,000 | 10% |
| $11,000+ to $44,725 | 12% |
| $44,725+ to $95,375 | 22% |
| $95,375+ to $182,100 | 24% |
| $182,100+ to $231,250 | 32% |
| $231,250+ to $578,125 | 35% |
| Over $578,125 | 37% |
Ordinary Income Tax Rates By Income (2023)
Filing status = married filing jointly
| Income | Marginal Tax Rate / Bracket |
|---|---|
| Up to $22,000 | 10% |
| $22,000+ to $89,450 | 12% |
| $89,450+ to $190,750 | 22% |
| $190,750+ to $364,200 | 24% |
| $364,200+ to $462,500 | 32% |
| $462,500+ to $693,750 | 35% |
| Over $693,750 | 37% |
For brevity, I omitted other tax filing statuses, including
- head of household
- married filing separately
The tax rates are also called “tax brackets” and “marginal tax” rates.
Historical US income tax rate brackets
Income from Capital Gains
- Capital gains is the profit you make from selling a capital asset.
- Capital assets include stocks, bonds, precious metals, jewelry, art, and real estate.
- Selling a capital asset after owning it for one year or less results in a short-term capital gain.
- Selling a capital asset after owning it for more than one year results in a long-term capital gain.
- Net capital gains are calculated based on your adjusted basis in an asset. This is the amount that you paid to acquire the asset, less depreciation, plus any costs that you incurred during the sale of the asset and the costs of any improvements that you made.
- Short-term capital gains are taxed as ordinary income from your salary or wages.
- Long-term capital gains are subject to a tax of 0%, 15%, or 20% (depending on your income).
Short-Term Capital Gains Tax Rates By Income (2023)
Filing status = single
| Income | Short-Term Tax Rate (same as ordinary income tax rate) |
|---|---|
| Up to $11,000 | 10% |
| $11,000+ to $44,725 | 12% |
| $44,725+ to $95,375 | 22% |
| $95,375+ to $182,100 | 24% |
| $182,100+ to $231,250 | 32% |
| $231,250+ to $578,125 | 35% |
| Over $578,125 | 37% |
Filing status = married filing jointly
| Income | Short-Term Tax Rate (same as ordinary income tax rate) |
|---|---|
| Up to $22,000 | 10% |
| $22,000+ to $89,450 | 12% |
| $89,450+ to $190,750 | 22% |
| $190,750+ to $364,200 | 24% |
| $364,200+ to $462,500 | 32% |
| $462,500+ to $693,750 | 35% |
| Over $693,750 | 37% |
If you have $90,000 in taxable income from your salary and $10,000 from short-term investments, then your total taxable income is $100,000.
Long-Term Capital Gains Tax Rates By Income (2023)
Filing status = single
| Income | Long-Term Tax Rate |
|---|---|
| Up to $44,625 | 0% |
| $44,626 to $492,300 | 15% |
| Over $492,300 | 20% |
Filing status = married filing jointly
| Income | Long-Term Tax Rate |
|---|---|
| Up to $89,250 | 0% |
| $89,251 to $553,850 | 15% |
| Over $553,850 | 20% |
Taxable Income
- Taxable income is the portion of your gross income that the IRS deems subject to taxes.
- It consists of both earned income and unearned income.
- Taxable income is generally less than adjusted gross income because of deductions that reduce it.
- Taxable income = Gross income – deductions
- For a business, revenue – business expenses = profit. Profit – deductions = taxable income.
Deductions
The IRS offers individual tax filers the option to claim the standard deduction or a list of itemized deductions.
Standard Deduction
The standard deduction is a set amount that tax filers can claim if they don’t have enough itemized deductions to claim. For the 2022 tax year, individual tax filers can claim a $12,950 standard deduction ($13,850 for 2023). If you are married filing jointly, the standard deduction is $25,900 ($27,700 for 2023).
Itemized Deductions
If you plan to itemize deductions rather than take the standard deduction, these are the records most commonly needed:
- Property taxes and mortgage interest paid (form 1098)
- State and local taxes paid (this is on form W-2 if you work for an employer)
- Charitable donations
- Educational expenses
- Unreimbursed medical bills
- Documents related to operating a rental property, such as receipts for repairs, advertising, etc. Learn more.
Tax Credits
A tax credit will lower your tax liability (any taxes you owe). If you don’t owe any taxes, then you may or may not get a refund, depending on the tax credit details. Some tax credit examples are
- 30% credit off the total cost of a solar panel installation
- $7,500 tax credit when you buy a qualifying electric vehicle
Refundable vs. Non-refundable Tax Credits
Refundable tax credit: If your tax credit is refundable, then even if you have no tax liability, e.g. if you are retired, then you will still get a refund for the entire tax credit amount.
Non-refundable tax credit: If your tax credit is non-refundable, then you will only get the full credit if your tax liability is at least as much as the tax credit. For example, if your tax credit is $1000 and your total tax liability before applying the credit is $1500, then your updated tax liability is reduced to $500. However, if your total tax liability before applying the credit is $800, then your updated tax liability is reduced to $0 and you will NOT get a refund for $200. For that reason, you should ensure your tax liability is at least as much as the tax credit you want to apply.
How to Calculate Taxable Income
- Determine Your Filing Status
- single,
- married filing jointly,
- etc
- Gather Documents for all Sources of Income
- form W-2 for earned compensation
- form 1099-INT for interest income
- etc
- Calculate Your Adjusted Gross Income (AGI)
Your AGI is the result of taking certain “above-the-line” adjustments to your gross income, such as contributions to a qualifying individual retirement account (IRA), student loan interest, and certain education expenses. These items are referred to as “above the line” because they reduce your income before taking any allowable itemized deductions or standard deductions. - Calculate Your Deductions (Standard or Itemized)
- Calculate Taxable Income
Taxable income = AGI – deductions
Marginal vs. Effective Tax Rates
The US has a progressive tax system, so your income is taxed at different rates. If your total annual income is $125,000 and your taxable income is $100,000 (income minus deductions and credits) and you are filing single, your tax liability would not be 24% of the entire $100,000. Instead, it would be $17,400. In this case, your “effective” or “average” tax rate is $17,400/$125,000 = 13.9%, which is much lower than 24%.
| Short-Term Income | Marginal Tax Rate | Tax Liability ($) |
|---|---|---|
| Up to $11,000 | 10% | $11,000 x 10% = $1,100 |
| $11,000+ to $44,725 | 12% | ($44,725 – $11,000) x 12% = $4,047 |
| $44,725+ to $95,375 | 22% | ($95,375 – $44,725) x 22% = $11,143 |
| $95,375+ to $182,100 | 24% | ($100,000 – $95,375) x 24% = $1,110 |
| $182,100+ to $231,250 | 32% | N/A |
| $231,250+ to $578,125 | 35% | N/A |
| Over $578,125 | 37% | N/A |
| Total | $17,400 |