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Commentary & Insights

Insight, Tax Planning

A Brief Overview of Federal Income Taxes

17 December 2019
Jeremy Runnels

By Jeremy Runnels

"The hardest thing in the world to understand is the income tax." – Albert Einstein

The U.S. tax system is riddled with complexities that baffle the greatest of minds (even Albert Einstein’s!). This brief overview is geared toward providing you with a cursory view of Uncle Sam’s role in your pocketbook.

Let’s break it down to this key question: How does the U.S. tax system work?

The Federal income tax is progressive and utilizes marginal tax brackets.

  • The more money you make, the more tax (as a percentage of income) you will pay.
  • Each bracket represents a bucket that needs to be filled up before you can move on to the next. The highest tax bracket you reach is called your marginal tax rate.
  • Moving into a higher tax bracket does not rob you of the benefits of the lower brackets. It simply applies a higher tax rate to each additional dollar of income you earn over the previous threshold. Making more money and paying a higher marginal tax rate still puts you in a better economic position.

In the U.S., the Federal income tax system is pay-as-you-go. As you earn income, you pay taxes on that income.

  • Most workers receiving W-2 income withhold federal income taxes from their paychecks based on the information they provided on their W-4 (that confusing form you filled out on your first day with HR). Depending on the number of dependents you claim, Uncle Sam will either take more or take less money from your paycheck.
  • If you receive income through a 1099, taxes aren’t automatically withheld. Instead, you are probably (or should be) putting money aside for Federal income taxes. 1099 employees or those without earned income pay their estimated tax owed on a quarterly basis.

When you file your Federal tax return before April 15th, you settle with the government for the previous year.

  • The government starts with your gross income and then subtracts deductions to reach your taxable income.
  • Next, your taxable income flows through the tax brackets mentioned above to arrive at your total tax owed.
  • Lastly, the government compares your total tax owed to what you withheld from your paycheck and/or paid through quarterly estimated payments.
    • Refund = you paid more tax than you owe.
    • Tax bill = you owe more tax than you paid.
  • You may also file an extension which allows you to extend your filing date up to 6 months (October 15th). However, your tax liability is still due on April 15th, and penalties can be applied if you don’t meet that deadline with payment.

Individual income taxes are the single largest category of revenue for the federal government, and Americans pay billions of dollars every year having their tax liability determined and their returns filed with the IRS. Taxes are complicated – there's no doubt about it. Our progressive tax system creates a common misconception that making more money will penalize you with higher taxes, but falling into a higher marginal tax bracket will likely still place you in a better economic position.