Federal Income Tax
Taxation is complex. We provide below what we believe are the key highlights for this tax type in a 2-3 minute read for reference purposes. It is not tax advice and does not discuss the vast majority of the finer points.
What Is Federal Income Tax? When/How Does It Apply?
Federal income tax is a tax levied by the U.S. government on most types of income earned by individuals and businesses in the country. For individuals, federal income tax frequently applies to many types of earnings:
Earned Income. Salary/wages, commissions, and bonuses
Stock Comp. RSUs and NSOs generate taxable income in many circumstances
Passive income. Savings account interest, fixed-income mutual funds, rental real estate, etc.
To determine how much federal income tax you owe each year the IRS uses a multi-step process to determine your taxable income, which is then applied against a progressive tax schedule (e.g. higher tax rates apply to higher levels of income). There is a lot of complexity and nuance in the calculation, but at a very high level:
Taxable income in the year is aggregated and combined for a household
Your household status (mostly) determines your tax filing status (single, head of household, married filing jointly, married filing separately)
You subtract any/all credits, deductions and adjustments you're eligible for
A progressive tax rate (which is different across tax filing status) is applied to the net of (i) your income (ii) less credits/deductions/adjustments.
You Have More Control Over Taxable Income (#1 Above) and Credits/Deductions (#2 Above)
Income. Outside of quitting their job, most salaried individuals have limited control over many portions of their income (e.g. salary; commissions; bonus). But in some situations, and certainly for other types of income, increased control exists:
If your company offers a deferred compensation plan -- you can potentially push income from one year into multiple future years
If you have stock options (ISO/NSOs), you have control over when you choose to exercise
Credits and deductions. At a minimum, every tax filer is eligible for a standard deduction (fixed amount based on your filing status). Beyond that, there are typically a number of additional items you can opt to participate in (or not) to modulate your taxable income:
Contributions to retirement accounts such as 401(k)s, IRAs, and FSA/HSAs are tax deductible (subject to phase-outs and maximum contribution amounts). Opting to contribute (or not) to these accounts can change your taxable income for a year by 5-20%-plus.
If your itemized deduction calculation exceeds your standard deduction --> then costs such as property/state taxes (up to a max limit), mortgage interest, certain medical expenses, and most charitable gifts can be either partially or fully deducted.
What Are the Current Tax Rates/Brackets?
For 2023, individual tax brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The amount of income taxed at each rate varies by filing status (single, married filing jointly, etc.).
| Tax Rate | Single | Married Filing Separately | Married Filing Jointly | Heads of Household |
|---|---|---|---|---|
10% | $0 to $11,000 | $0 to $11,000 | $0 to $22,000 | $0 to $15,700 |
12% | $11,000 to $44,725 | $11,000 to $44,725 | $22,000 to $89,450 | $15,700 to $59,850 |
22% | $44,275 to $95,375 | $44,725 to $95,375 | $89,450 to $190,750 | $59,850 to $95,350 |
24% | $95,375 to $182,100 | $95,375 to $182,100 | $190,750 to $364,200 | $95,350 to $182,100 |
32% | $182,100 to $231,250 | $182,100 to $231,250 | $364,200 to $462,500 | $182,100 to $231,250 |
35% | $231,250 to $578,125 | $231,250 to $346,875 | $462,500 to $693,750 | $231,250 to $578,100 |
37% | $578,125 or more | $346,875 or more | $693,750 or more | $578,100 or more |
🔗 The Tax Foundation (2023 Inflation Adjusted Tax Brackets)
Withholding Requirements
When you earn income, your employer is typically, but not always, required to withhold a portion of your pay for federal income taxes. The amount withheld depends on several factors, including your income, marital status, number of allowances claimed, and the type of income.
Withholding on Salary and Wages
For regular salary and wages, your employer withholds based on the information you provide on Form W-4. The more allowances you claim on your W-4, the less tax will be withheld. If too little tax is withheld from your paychecks, you may owe taxes when you file your return. It’s a good idea to review and update your W-4 periodically to ensure the proper amount of tax is being withheld.
Withholding on Bonuses and Supplemental Income
Bonuses, commissions, and other supplemental income are often subject to a flat withholding rate of 22% (if/until income exceeds $1m, after which this increases to 37%). This means 22% of your bonus may be withheld for taxes. However, the tax you owe on bonuses are likely to be higher than 22% since it's additive to your overall income (and typically pushes individuals into higher tax brackets). You may need to pay additional tax when filing your return or make quarterly estimated tax payments to avoid potential underpayment penalties.
No Withholding on Certain Types of Income
Some forms of income, like passive income, self-employment income, and income from ISO disqualifying dispositions do not have any tax withheld. You are still responsible for paying income tax on these however, and you may also want/need to pay quarterly estimated taxes to avoid penalties and interest charges.
Important: The IRS generally requires you to pay on the taxes you anticipate to owe when you earn it. If you fail to do so, you could owe penalty fees. Tax withholding accomplishes this for most people in most situations, but if you have a situation where withholding may not apply (or be too low), you may want/need to consider paying estimated taxes. If this applies to you, we also recommend researching/understanding Federal Safe Harbor exemptions.
What Types of Stock Comp Does This Apply To?
| Stock Comp Type | Federal Income Tax Applicability |
|---|---|
ISOs | Maybe. No tax at grant or exercise. A disqualifying disposition sale will be taxed as ordinary income; a qualifying disposition will not. For more info see: ISO Stock Options |
NSOs | Most Likely. If the FMV is greater than the strike price when you exercise, you'll owe income tax. The company is required to withhold taxes when NSOs are exercised. For more info see: NSO Stock Options |
RSUs | Yes. Individuals pay income tax when RSUs vest and shares are issued. The company is required to withhold taxes when RSUs are exercised. For more info see: Restricted Stock Units (RSU) |
ESPPS | Most Likely. Employees will owe income tax on the discounted purchase amount if there was one. Depending on the ESPP plan details and when shares are sold, income tax may be owed on other aspects as well. For more info see: Employee Stock Purchase Plan (ESPP) |
RSAs | Unlikely. Nearly all RSA grants are 83b early exercised (obviating any future income tax). In a very rare circumstance where this did not occur, then ordinary income taxes would apply as RSAs vest. For more info see: Restricted Stock Award (RSA) |
SARs | Yes. Employees pay income tax on the amount of cash received upon exercise of SARs. For more info see: Stock Appreciation Right (SAR) |
Phantom Stock | Yes. Employees pay income tax on the amount of cash paid upon vesting of phantom stock units. For more info see: Phantom Stock |
Unique Items and Special Situations
Different Types of Earned Income Have Different Withholding Requirements
Ordinary income is withheld at the normal income tax rate
Supplemental income is withheld at a flat 22% rate under $1 million, 37% rate exceeding $1 million
Income with no withholding includes interest, dividends, capital gains, self-employment income, etc.
Estimated Tax Payments
Individuals with income from sources other than wages may need to pay quarterly estimated taxes to avoid underpayment penalties.
This includes those with income from self-employment, interest, dividends, capital gains, stock options, etc.
Itemized vs. Standard Deduction
The standard deduction is a flat amount based on filing status. It is indexed to inflation and has increased in recent years.
Itemized deductions will apply if they exceed your standard deduction. Things like mortgage interest, charitable donations, and state/local taxes paid.
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