Taxes: What is Income Tax?

September 03, 2018

Governments cannot operate without money. There are all kinds of taxes you may owe the government at some point in your life—property tax, capital gains tax, and gift tax, to name a few. The federal income tax system in this country is progressive. “Progressive” in tax terms means that those with higher income pay are placed in a higher tax bracket and taxed at a great percentage of their income.

Key definitions

There are a few terms that are important to understand.

  • A tax credit is a straightforward, dollar-for-dollar reduction in your tax liability. If you owe $5,000 in income taxes for a given year and you qualify for a $1000 tax credit, you now owe only $4000. Tax credits are available for things like childcare, buying a home, and college tuition—as discussed in the section on educational tax considerations. It's important to note that you cannot use tax credits to lower your tax burden below zero.
  • A tax deduction, on the other hand, reduces your taxable income. This means it is not a dollar-for-dollar reduction of your tax burden, like a tax credit, but rather a reduction by the percentage of your tax bracket. To illustrate this difference, consider the scenario mentioned above. A $1000 tax credit results in a $1000 reduction of your tax burden. However, a $1000 tax deduction results in a $250 reduction of your tax burden if you are in the 25% income bracket ($1000 * 25% = $250), a $150 reduction if you are in the 15% bracket, etc.

Do I need to file?

You are only required to file a tax return if your income is above a certain threshold. The thresholds are different for individuals, married persons, and those who are claimed as dependents on their parents' tax return. As of 2017, individuals under the age of 65 must file a tax return if they earn $10,400 annually or more. The full set of rules is available here.

Even if you are not required to file, it's generally a good idea to do so, as you may actually receive a refund (yes, you'll receive money!) due to paycheck withholding.

Money worries can be a thing of the past!

Haven helps you save and invest automatically. Build a safety net, then invest your money without lifting a finger.

Get started