Last month, the IRS announced their 2025 increases in federal income tax brackets as well as increases in standard deductions. Federal income tax brackets refer to the tax you the federal government. This tax is a percentage of your income where you fall into a particular layers called tax brackets depending on your annual income. As your income increases, you may fall into a high tax bracket which means the percentage of your income which you owe to the federal government increases.
The difference between federal and state income tax
All Americans, no matter where you live, must pay federal income tax if you earn a large enough annual income to fall into the first federal tax bracket and beyond. This also includes all Americans who are domiciled in a foreign country or Americans who live in the U.S. but are employed by an international employer. The bottom line is, if you are an American and you are employed, you are liable to pay federal income tax. The federal income tax rate is progressive, meaning that the more money you make the higher percentage of your income you owe.
State income tax on the other hand varies depending on where you live. State income tax contributes to the functioning and funding of each relative state. Some states are similar to the federal income tax system whereby a progressive system is used while others employ a flat rate. A flat income tax rate means that no matter how much income you earn, you will be taxed at the same rate. This is good news for individuals who start to earn more money and don’t want to pay more of their income in tax.
Some states do not have any state tax. These states include Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. Some of these states are home to a large number of retirees for this reason. New Hampshire does not have state income tax but will tax individuals on income from interest and dividends and not earned income from salary and wages. However, this is being phased out by 2025.
Significant changes to federal income tax brackets in 2018
In 2018, the Tax Cuts and Jobs Act (TCJA) was passed. This piece of legislation significantly changed the structuring of federal income tax brackets. It was the largest tax code overhaul in three decades and created a single flat corporate tax rate of 21%. However, most of the benefits which were enacted in the legislation will expire in 2025.
The law kept the seven income tax brackets, but changed the interest rates. The top rate fell from 39.6% to 37%, while the 33% bracket dropped to 32%, the 28% bracket to 24%, the 25% bracket to 22%, and the 15% bracket to 12%. The lowest bracket remained at 10%, and the 35% was unchanged. This structuring has remained the same for 2025’s federal income tax brackets.
Changes to 2025 tax brackets to keep up with inflation
Each year, the IRS announces changes to the seven bracket thresholds in order to keep up with inflation rates. This is done to ensure “bracket creep” does not occur.
“Bracket creep occurs when inflation, rather than real increases in income, pushes people into higher income tax brackets or reduces the value they receive from credits and deductions,” says Alex Durante, an economist at the Tax Foundation.
