Income Tax

How income tax works

In a progressive system like the US:

• Tax brackets — income is divided into ranges, each taxed at its own marginal rate.
• Marginal rate — the rate on the next dollar earned. Going into a higher bracket only taxes additional income at the higher rate, not all of it.
• Effective rate — the average rate you actually pay across all your income. Lower than your marginal rate.

For 2025 US federal income tax, single-filer brackets are roughly:

• 10% up to ~$11,925
• 12% up to ~$48,475
• 22% up to ~$103,350
• 24% up to ~$197,300
• 32% up to ~$250,525
• 35% up to ~$626,350
• 37% above

A single filer earning $200,000 doesn't pay 24% on all $200K. They pay 10% on the first chunk, 12% on the next, 22% on the next, etc. — total federal tax around $40K, an effective rate of about 20%.

Common deductions and credits

Two ways to reduce taxes owed:

• Deductions reduce taxable income. A $10,000 deduction at a 24% marginal rate saves $2,400.
• Credits reduce tax owed dollar-for-dollar. A $1,000 credit saves exactly $1,000.

Major US ones:

• Standard deduction — flat amount most filers take. $15,000 for singles in 2025; $30,000 for married couples.
• Itemized deductions — alternative for filers whose specific deductions exceed the standard deduction. Includes mortgage interest, state and local taxes (capped at $10K), charitable donations, medical expenses (above threshold).
• Tax credits — child tax credit, earned income credit, education credits, foreign tax credit, etc.
• Above-the-line adjustments — HSA contributions, Traditional IRA contributions, student-loan interest, self-employed retirement contributions.

State income taxes

Most US states impose their own income taxes:

• No state income tax — Texas, Florida, Washington, Tennessee, Wyoming, South Dakota, Nevada, Alaska, New Hampshire (limited).
• Flat-rate states — Colorado (4.4%), Illinois (4.95%), Indiana (3.05%), Massachusetts (5%), Michigan (4.05%), and others.
• Progressive-rate states — California (up to 12.3%, plus 1% on $1M+), New York, New Jersey, Hawaii, others.

Combined state and federal can exceed 50% marginal rates in high-tax states for high earners. State residency for income-tax purposes can be a major financial planning factor.

Different income types

Different types of income are taxed differently:

• Wages — taxed at ordinary rates. Subject to payroll taxes (Social Security, Medicare).
• Self-employment income — taxed at ordinary rates. Subject to self-employment tax (15.3% covering both employer and employee portions of payroll taxes).
• Long-term capital gains — taxed at preferential rates (0%, 15%, 20% federally).
• Short-term capital gains — taxed as ordinary income.
• Qualified dividends — taxed at long-term capital-gains rates.
• Interest income — taxed as ordinary income.
• Municipal bond interest — typically tax-exempt federally; sometimes also state-exempt.
• Social Security benefits — taxed up to 85% depending on total income.

Withholding and estimated payments

Most US workers pay through:

• Payroll withholding — employer deducts taxes from each paycheck and sends to the IRS.
• Quarterly estimated payments — for self-employed and high-income filers with significant non-payroll income. Quarterly deadlines (April, June, September, January).
• Tax-time true-up — annual filing reconciles total liability with what was withheld; refund or balance due.

Underpayment can trigger penalties. The "safe harbor" rules generally require paying either 100% of prior year's tax or 90% of current year's tax through the year.

Major tax-saving strategies

A few important ones:

• Tax-advantaged accounts — 401(k), IRA, HSA contributions reduce current-year taxable income.
• Tax-loss harvesting — realizing capital losses to offset gains.
• Holding periods — long-term capital gains rates apply after 1 year of holding.
• Roth vs. traditional decisions — bet on future vs. current tax rates.
• Charitable giving — donating appreciated stock; donor-advised funds; charitable remainder trusts.
• Bunching deductions — alternating years of itemizing and taking standard deduction.

Self-employment

Self-employed individuals face additional complexity:

• Self-employment tax (15.3%) on net self-employment income, with 50% deductible against income tax.
• Quarterly estimated tax payments required.
• Solo 401(k) or SEP-IRA for retirement contributions; much higher limits than W-2 employees.
• Business expense deductions — home office, business equipment, travel, half of health insurance.

The complexity is real but the deductions can offset some of the additional tax burden. Working with a CPA or tax software designed for self-employed filers usually pays off.

Tax filing software

Most US filers use:

• Free File programs — IRS partnership for low-to-moderate income filers.
• TurboTax, H&R Block, TaxSlayer — major commercial options.
• CPA preparation — for complex situations.
• DIY paper or PDF filing — uncommon but legal for those who want to.

The IRS Direct File program (rolled out gradually) provides free filing for simple returns directly through the IRS.

International perspective

Tax structures vary widely:

• Many European countries have higher top marginal rates but more comprehensive social benefits.
• Tax-free or low-tax countries (UAE, Monaco, etc.) attract wealthy individuals.
• The US is unusual in taxing worldwide income of citizens regardless of residence — most countries tax based on residency rather than citizenship.
• Foreign tax credits prevent most double taxation for cross-border earners.

Internationally mobile individuals face significantly more complex tax planning than domestically-rooted ones.

What individuals should care about

For most workers:

• Understand your effective rate — many people overestimate how much tax they pay marginally.
• Maximize tax-advantaged accounts — match in 401(k), then Roth IRA or HSA, then more 401(k).
• Holding periods matter for capital gains.
• State residency matters for high earners — moving from California to Texas can save 12-13% per year.
• Consult a professional for complex situations — equity compensation, business income, multi-state earning, large capital events.

The US tax system is complex enough that most filers benefit from at least some software assistance. Optimizing it can produce meaningful savings without aggressive tax positions.