Q: What’s the difference between Federal Income Taxes and State Income Taxes?
A: US law dictates that both individuals and businesses must pay annual taxes on earned income to the federal government. In 2016, the federal government received $3.13 trillion dollars in revenues, $1.3 trillion of which came come individual income taxes—the largest single source of this revenue.40 These tax dollars are used to support a wide variety of government programs and initiatives—everything from the military and federal and welfare programs to highways and disaster relief.41
State taxes are a little bit of a different story. Since state taxes are governed by the states themselves, they vary from state to state. And while many states follow a model that looks quite similar to federal taxes, some states really go their own way. Pennsylvania, for example, imposes a flat tax—meaning everyone pays the same amount, instead of being taxed according to income—while some states impose no state taxes at all!42
Q: What’s the difference between “taxable income and “non-taxable income”?
A: Generally, you can assume all income is taxable unless it’s explicitly designated as tax-exempt by the IRS. Taxable income includes all the usual suspects—all wages, tips, bonuses, investment income—but also a few surprises. For example, even bartering—what the IRS defines as “an exchange of property or services” (that is, a non-monetary exchange) is considered taxable income.43 If you’re not sure, check out the IRS taxable income page for more information.
Non-taxable income, then, would be items like inheritances, cash rebates, received welfare and child support payments.44
Q: What is the difference in a “tax credit” and “tax deduction?”
A: Both tax credits and tax deductions can help you reduce your overall tax liability (the amount you owe in taxes), but they work a little differently.
According to the IRS, a tax credit “provide[s] a dollar-for-dollar reduction of your income tax liability.”
By comparison, a tax deduction lowers your taxable income by allowing you to deduct a percentage of qualifying expenditures you made during the previous year. Donating to a charity, paying interest on a mortgage, or healthcare costs that exceed 10% of your AGI (adjusted gross income) are all qualifying tax deductions.
So what’s the difference? A tax deduction is affected by your tax rate. This means that you’ll only be able to subtract a percentage of the overall deduction (the same percentage at which all your income is taxed) from your overall tax liability. Here’s the example the IRS gives: if you fall into the 25% tax bracket, a $1,000 tax deduction will only net you $250 dollars in savings, while a $1,000 tax credit means $1,000 saved. For a complete list of qualifying deductions, visit the IRS website.
OK—so what’s the difference between a “tax deduction” and a “standard deduction?”
The IRS gives you a choice between itemizing (adding up) your list of tax deductions from the previous year or taking a standard deduction.
A standard deduction is a deduction amount that’s pre-set each year by the IRS; standard deductions vary based on filing status and tax bracket. It’s important to note that you can’t claim both a standard deduction and your itemized list of deductions, so you’ll want to pick the option that saves you the most money. For many people, the standard deduction is the higher amount. However, if you’ve had large medical bills or made large contributions to tax-deductible organizations, for example, you might come out better itemizing your deductions.45
Table of Contents:
- Taxes: the basics
- How do taxes work anyway?
- Step 1: Preparing to File
- Step 2: Select your method of filing
- Step 3: Filing & receiving your tax return
- Glossary of terms you may encounter
- Tax FAQs
- About the experts
- Works Cited