Income Tax

Federal law starts from a broad rule. Gross income means all income “from whatever source derived,” the Sixteenth Amendment’s phrase, which the tax code still uses. It covers pay for work, business income, gains on property, interest, rents, dividends, pensions and annuities, and an amount is generally taxable unless a specific provision excludes it.

The tax is collected as you go. Employers withhold it from each paycheck based on your Form W-4, and people with self-employment, investment or retirement income that has nothing withheld make quarterly estimated payments. Paying too little during the year can bring a penalty even if you settle up later. The return you file after the year ends is the reconciliation: it works out what you actually owe, subtracts what you already paid and produces a refund or a balance due.

The federal tax is only one layer: most states also levy a state income tax, with brackets or a single flat rate, and some cities and counties add a local tax.

Every federal return follows the same sequence, from total income down to a refund or a balance due. Rates apply to taxable income, not to everything you earn. Credits come off the tax itself rather than off income, which is why a $1,000 credit is worth far more than a $1,000 deduction: the deduction saves only your bracket rate on $1,000. The steps below use 2026 figures, and the worked example further down runs them for one family.

Most money you receive counts. Beyond paychecks, that includes self-employment profit, bank interest, dividends, rental profit, gains when you sell investments or property for more than you paid, pensions and annuities, and traditional IRA and 401(k) withdrawals. A Roth conversion is taxed as ordinary income in the year you convert, and up to 85% of Social Security benefits can be taxable once your income passes set thresholds.

Some income is excluded by law or taxed lightly. Gifts and inheritances you receive are not income to you, although an inherited traditional IRA is taxed as you withdraw from it. Qualified Roth IRA withdrawals are tax-free, and interest on most state and local bonds is exempt from federal income tax. Long-term capital gains and qualified dividends are taxable, but at 0%, 15% or 20% instead of ordinary rates, and they stack on top of your ordinary income when the rate is chosen.

Not every break is permanent. Several deductions created in 2025, including those for tips, overtime and people 65 and older, run only through 2028.

People often say “income tax” for everything taken out of a paycheck, but two separate federal taxes are withheld. Income tax funds the general government and uses the bracket system. FICA payroll tax funds Social Security and Medicare: in 2026 employees pay 6.2% on wages up to $184,500 plus 1.45% on all wages, and an extra 0.9% Medicare tax applies to wages above $200,000 ($250,000 for joint filers). Employers match the 6.2% and 1.45% but not the extra 0.9%, and self-employed people pay both halves as self-employment tax.

The difference matters most in retirement. Pensions, IRA withdrawals and investment income owe income tax but no payroll tax, so a retiree often keeps more of each dollar than a worker earning the same amount. The table below lists the federal taxes that fall on income in 2026.

Every lever works on one step of the calculation: it shrinks taxable income, moves income to a lower rate, cuts the tax with a credit, or shifts income into a year when your marginal tax rate is lower. Timing matters as much as amount, because the rules apply one year at a time. Peak earning years usually carry the highest rates, while the years between leaving work and the start of Social Security or required distributions are often the lowest. Judge a move by the total paid over many years, not by one year’s effective tax rate.