What Is Income Tax?

Income tax is an annual tax paid to the government based on individual income. Both earned income and unearned income are taxed. In the US, these taxes are paid to the Internal Revenue Service, or IRS, on a federal level, while other taxes are collected by state and local government entities.

Federal income taxes on earned income are generally withheld by your employer and paid directly to the government. These taxes include general taxes, as well as the FICA tax, which is paid toward social security. If you’re self-employed, you pay these taxes as a Self-Employment Tax in addition to the normal taxes paid on your income.

Federal taxes on unearned income include taxes on interest, such as that paid to you by your bank, dividends, such as money made through sale of stock, and rent paid to you by a tenant of a property you own. Other passive income streams are also included in the unearned income category for purposes of taxation.

In addition to federal taxes, most states collect an annual state income tax. Local and state taxes, too, are generally withheld from your paycheck by your employer. If, at the end of the year, you discover your employer has withheld more taxes than you actually owe, you are issued a refund. If you haven’t paid out enough, you have to pay the difference.

Ways to Reduce Your Tax Burden

The tax code is very complex, and seems to become more complex every time a revision is issued. Within the tax code are several ways to reduce the amount of taxes you owe, based on your income, deductions, and various available tax credits.

The number one way to reduce your taxes is to reduce your income. This doesn’t mean going out and getting a lower-paying job—although obviously that would reduce your tax burden. This means finding ways to reduce the amount of Adjusted Gross Income (AGI) you are required to pay taxes on.

One of the best ways to reduce your AGI is to redirect part of your income to a retirement plan such as a 401k or IRA. Any money placed in these plans is subtracted from your earned income, reducing the amount of money you have to pay taxes on. Other costs that can be subtracted directly from your AGI include interest you’ve paid on student loans and any money you’ve paid out as alimony.

Another way to reduce your taxes is to make use of allowable deductions. Depending on your circumstances, a large number of these are available for you to make use of. If you own your own business, either full- or part-time, business expenses can be deducted. Mortgage interest provides another large deduction, as can charitable donations and, under certain circumstances, medical expenses. Some of these deductions involve complex calculations or detailed eligibility requirements, so if you’re uncertain about taking any of them, consult a qualified tax professional.

Tax credits can also significantly reduce your income taxes. Tax credits aren’t subtracted from your AGI, but from your owed taxes. Examples of tax credits include:

* Child Tax Credit—Subtracts $1,000 for each eligible child
* Earned Income Credit—A credit for low-income filers
* Higher education credits

In addition to these, a miscellany of other specialty credits exists. The best way to ferret out all your eligible tax credits is to consult with a tax specialist. By finding all the possible ways to reduce your AGI, deduct from your income, and acquire tax credits, you can greatly reduce your tax burden and keep more of your money in your pocket.

What Is Income Tax?

Ways to Reduce Your Tax Burden

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