How Income Taxes Work

The Internal Revenue Service (IRS) estimates that Americans, both individuals and businesses, collectively dedicate approximately 8 billion hours each year to comply with tax-filing requirements. To put this immense effort into perspective, if these tasks were consolidated under a single entity, it would require a workforce of approximately four million full-time employees, effectively making it one of the largest industries in the United States.¹

Despite the complexity of tax regulations, the process of income taxation is fundamentally straightforward. Nonetheless, a significant portion of the American population prefers not to engage directly with the intricacies of tax preparation, leading more than half of taxpayers to enlist the assistance of professional tax advisors for their annual filings.²

It is essential to note that this information is not intended as a substitute for personalized tax or legal advice. For specific guidance related to your unique financial situation, it is advisable to consult with a professional possessing expertise in tax or legal matters.

Determining Gross Income

Commencing the tax process hinges on one’s income, encompassing various revenue streams that are generally subject to taxation. These sources encompass earnings from employment, investments, interest, pensions, and other avenues of income. The aggregate of these income sources constitutes the taxpayer’s gross income.

Conversely, certain receipts are not categorized as taxable income, such as gifts, inheritances, workers’ compensation benefits, welfare assistance, or cash rebates provided by dealers or manufacturers.³

Following the determination of gross income, specific adjustments are deducted. These adjustments might include contributions to retirement plans, a portion of self-employment income, and other relevant items. The outcome is referred to as the adjusted gross income.

Identify Deductions

Subsequently, deductions are subtracted from the adjusted gross income. Taxpayers are typically presented with two choices for deductions: the standard deduction or itemized deductions. The standard deduction amount fluctuates based on the taxpayer’s filing status. An informative chart provided by the IRS details these variations.

Itemized deductions, on the other hand, can include state and local taxes, charitable contributions, mortgage interest, and particular unreimbursed job-related expenses, among other eligible expenses. Notably, there exist limitations on the amount of state and local taxes that can be deducted.⁴

After deductions are accounted for, the outcome is the taxable income, which in turn determines the gross tax liability. Nevertheless, the tax process is not yet complete.

Understand Your Liability

Any applicable tax credits are then subtracted from the gross tax liability. Taxpayers may qualify for credits related to various factors, including energy-efficient home improvements.

The final result is the taxpayer’s net tax liability, reflecting the amount owed or refunded.

While comprehending the tax process is one aspect, executing the necessary steps can be considerably more intricate. Therefore, it is advisable to consult professionals with expertise in tax or legal matters to ensure accurate compliance with tax regulations.

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1. NTU.org, April 18, 2022
2. IRS.gov, 2023
3. The tax code allows an individual to gift up to $17,000 per person in 2023 without triggering any gift or estate taxes. An individual can give away up to $12,920,000 without owing any federal tax. Couples can leave up to $25,840,000 without owing any federal tax. Also, keep in mind that some states may have their own estate tax regulations. This material is not intended as tax or legal advice. Please consult a professional with tax or legal experience for specific information regarding your individual situation.
4. The mortgage interest deduction is the first $750,000 of the loan for a home and the state and local income taxes deduction is capped at $10,000.