What Are Taxes?
Taxes are a method for the government to collect money from individual citizens and businesses to pay for the needs and wants of our country, states, counties, cities, and municipalities. A city may need traffic stop signs, but they may also want a football stadium. The needs are known as mandatory spending and wants are discretionary spending. For some taxes to go into effect, a vote from “we, the people” approving how the money will be spent is necessary. Other taxes directly go to fund things like education, schools, health care, military, police and fire departments, libraries, and social security.
The Three Most Common Types of Taxes
#1 Federal and State Income Tax
If you are employed, you complete a W-2 and based on your deductions, and that determines the tax amount deducted from your paycheck. If you are self-employed or have income from sources like rent, profits, and other sources, you pay taxes quarterly or annually on this income directly to the state and the federal government.
When you receive your paycheck, did you notice it was less than expected?
Welcome to income taxes. Grab your paystub and examine how much you made and how much you received.
Compare the gross income to your net income on your pay stub, you’ll see that some of the money was deducted to pay your state and federal taxes. That is income tax. The differences are:
Gross Income — The sum of all wages and salaries, also known as gross pay, from your paycheck before any taxes or deductions. Beyond your paycheck, investment income such as profits, interest, payments, rents, or earnings from other sources is considered gross income or gross profit.
Net Income —On your paycheck, gross income minus taxes and other deductions (such as healthcare and investment plans) equals your net income or net pay.
The amount of income tax deducted from your paycheck is determined by the following items:
Dependents — Qualifying people who receive at least half of their financial support from you, such as a child or other relative. The more dependents you have, the less income tax you pay, which helps offset the cost of their care from your income.
Filing Status — Determines your filing requirements, your standard deduction amount, eligibility for credits, and tax rate. There are five filing statuses: Single, Married Filing Separately, Married Filing Jointly, Head of Household, and Qualified Widow/Widower.
Taxable Income — Some or all sources of your income and is reduced by expenses and other deductions (such as dependents).
Your taxable income, not your gross income, is a determining factor for your tax bracket, which is the percentage rate of your income tax. Lower incomes are taxed at a low percentage rate, while higher incomes are taxed at a higher rate.
#2 Property Tax
Owning property, such as a house, building, or land, is taxable. The taxes you pay as a property owner are calculated by and paid to the local government where your property is located. The amount of tax owed is primarily based on the value of the property itself, but the amount can fluctuate yearly as the value of your property and surrounding properties. Income taxes go to pay for societal expenses on a federal and state level, and property taxes are used to pay for things often closer to home (or at least closer to the property). Local road repair and construction, education, public parks, city maintenance, and even local government employee salaries are all partially paid for by our property taxes.
#3 Sales Tax
Ever notice the price that you pay for an item or service is higher than the price listed? That was because you paid a sales tax. Sales tax is a fee added to the price of goods (items) and services that are collected from the retailer (seller) and paid to local and state governments. Item or service price plus sales tax equals the price you pay. Varying rates of sales tax rates are set by individual states, counties, and cities. Some locations charge no sales tax at all. Also, some states do not require adding sales tax to items deemed for basic needs, such as food and clothing. Taxing can vary even with the food example with food purchased from a store not taxed, but food from a restaurant deemed taxable. In that example, one purchase is considered a basic need, while the other is viewed as a luxury. Like property taxes, our states, cities, and municipalities use sales taxes to pay for roads, schools, emergency, and other services for citizens on more of a local level up to the state level.
Income, property, and sales tax are the three most common types of taxes. There are thousands of pages of tax code that affect the amount of taxes each individual is required to pay.
Here we have provided you with a broad overview of this subject. If you are interested in learning more, get professional help from a CPA or do further research at the American Institute of CPAs website on this essential subject.
Adjusted Gross Income (AGI) – Gross income reduced by adjustments to income before exemptions and deductions are applied.
Deduction – An amount subtracted from your taxable income for certain expenses.
Dependent – A child or relative whom you support and who qualifies you to take an exemption.
Exemption – A type of deduction claimed for yourself, your spouse (if filing jointly), and each dependent.
Filing Status – A category of taxpayer. Each taxpayer must select a filing status on their tax return: Single, Head of Household, Married Filing Jointly, Married Filing Separately, or Qualifying Widow(er). Filing status determines things such as your overall tax rate, eligibility, and income limits for various credits and deductions.
Gross Income – The total amount of your income before applying adjustments, exemptions, credits, and deductions.
Head of Household – A filing status claimed by taxpayers who are single but have qualifying dependents.
IRS/Internal Revenue Service – A bureau of the Department of the Treasury and the federal government agency responsible for collecting taxes and for enforcing the tax code.
Itemized Deduction – A deduction for a specific expense that may be claimed if the total amount of all itemized deductions is greater than the standard deduction (see the definition for standard deduction).
Local Tax – A tax charged by a local government, such as a city or county.
Luxury Tax – An indirect tax attached to certain expensive, nonessential goods or services such as sports cars or jewelry.
Married Filing Jointly – A filing status claimed by married couples who opt to combine income and file a single tax return together to take advantage of various tax benefits.
Married Filing Separately – A filing status claimed by married couples who do not want to file a joint return and agree to report their income separately.
Penalty – Charges added to your tax bill for late filing and late payment. The IRS and state governments may also charge interest for late tax payments.
Property Tax – A tax paid for ownership of property, such as houses and land.
Qualifying Widow(er) – A filing status claimed by a taxpayer whose spouse has died during the tax year and entitles the taxpayer to the tax rates and benefits of a joint return. If a widow(er) has dependents and does not remarry, that person may be allowed to claim Qualifying Widow(er) status for two more years.
Refund – The amount of money you receive back from the IRS or state when you have paid more taxes than you owe.
Sales Tax – A tax on retail products, goods, and services, based on a certain percentage of the sale price and is generally set by the state and local governments.
Single – A filing status claimed by those who are unmarried, divorced, or legally separated and who do not qualify for Head of Household status.
Standard Deduction – A specific amount that differs by filing status. You may deduct this amount from your taxable income if you do not itemize deductions.
Tax Bracket – A range of incomes that determines a specified tax rate.
Tax Liability – The total amount of taxes you owe for that tax year, determined by your tax rate.
Tax Rate – The percentage of income owed as tax.
Tax Year – The 12-month period covered by a tax return.
Taxable Income – The amount of income that is taxed. The remaining sum of your Adjusted Gross Income (AGI) after all applicable exemptions, credits, and deductions have been subtracted.
Withholding – Money held back from your paycheck and used to pay a portion of your annual taxes.