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Income Tax Basics

Income Tax Basics

Understanding how income tax works is essential for every American worker and investor. This lesson covers the fundamentals of calculating and paying federal income tax.

Gross Income

Gross income includes all income from whatever source derived, unless specifically excluded. Common sources include:

  • Wages and salaries
  • Self-employment income
  • Interest and dividends
  • Capital gains (profits from selling assets)
  • Rental income
  • Alimony (for agreements before 2019)
  • Retirement distributions (from IRAs, 401(k)s)
  • Unemployment compensation

    • Exclusions from Gross Income

    Certain types of income are excluded:

  • Municipal bond interest
  • Life insurance proceeds (generally)
  • Gifts and inheritances (though the giver may owe gift tax)
  • Qualified scholarships
  • Employer-provided health insurance premiums
  • Workers' compensation benefits

    • Adjusted Gross Income (AGI)

    AGI is gross income minus specific above-the-line deductions (adjustments):

  • Contributions to traditional IRAs
  • Student loan interest (up to $2,500)
  • Self-employment tax deduction (half of self-employment tax)
  • Health savings account (HSA) contributions
  • Educator expenses

    • AGI is important because many tax benefits are subject to AGI phase-outs.

    Standard vs. Itemized Deductions

    After calculating AGI, taxpayers reduce their income by either:

  • Standard deduction — a fixed amount based on filing status (most taxpayers choose this)
  • Itemized deductions — specific expenses including state and local taxes (SALT, capped at $10,000), mortgage interest, charitable contributions, and medical expenses exceeding 7.5% of AGI

    • Filing Status and Tax Brackets

    Your filing status determines your standard deduction and tax bracket thresholds:

  • Single
  • Married filing jointly
  • Married filing separately
  • Head of household
  • Qualifying surviving spouse

    • Tax rates range from 10% to 37% across multiple brackets in the progressive system.

    Tax Credits vs. Deductions

  • Deductions reduce your taxable income (the tax benefit depends on your marginal rate)
  • Credits directly reduce your tax liability dollar-for-dollar (more valuable than deductions)
  • Credits may be refundable (you can receive money back even if you owe no tax) or nonrefundable (can only reduce tax to zero)

    • Quiz: Income Tax Basics

    Question 1 of 3

    What is the difference between a tax credit and a tax deduction?