What it is:
Income tax refers to annual taxes levied by the federal government and most state governments on individual and business income. By law, businesses and individuals must file federal and state income tax returns every year to determine whether they owe taxes. Governments use the taxes they collect to fund their activities.
How it works/Example:
Income tax is applied to both earned income (wages, salaries and commission) and unearned income (dividends, interest and rents).
The U.S. and many other countries employ a progressive income tax system in which higher income earners pay a higher tax rate compared to their lower earning counterparts. The intent of progressive systems is to distribute wealth more evenly across a population.
Here's an example of how a progressive tax is structured: Assume you are single and report $80,000 in taxable income for the 2010 tax year (filing in 2011). In accordance with the federal tax rates defined for single filers in 2010, the first $8,350 of your income is taxed at 10%; the next $8,351 through $33,950 of earnings are taxed at 15%; and the remaining $33,951 through $80,000 of your earnings are taxed at 25%.
[Click here to see our Progressive Tax Definition and Example.]
Why it matters:
Income taxes reduce the amount of earnings that individuals and businesses are allowed to keep. There are a couple of strategies investors can use to retain more of their income. The first is investing in tax-advantaged assets like U.S. government bonds and municipal bonds.
The second is to open a retirement account that is tax-advantaged. An IRA, 401(k), SEP IRA and Roth IRA are all examples of tax-advantaged accounts. Investors can hold any asset they like within these accounts. The tax benefits of a retirement account don’t depend on the investments you hold in the account.