Every April we have to go through filing federal income taxes, on our own or with the help of a tax accountant. Unless you happen to be a tax policy wonk, you probably don’t dwell too much on the theory and practice of taxation. But while America’s tax code is notoriously complex, taxes break down into discrete categories that are easy to understand.
A consumption tax is a tax on the money people spend, not the money people earn. Sales taxes, which state and local governments use to raise revenue, are a type of consumption tax. An excise tax on a specific good, such as alcohol or gasoline, is another example of a consumption tax. Some economists and presidential candidates have proposed a federal consumption tax for the U.S. that could offset or replace taxes on capital gains and dividends.
This is a tax that is higher for taxpayers with more money. In a progressive tax system like the U.S. federal income tax, wealthy individuals pay tax at a higher rate than less wealthy individuals. This is why wealthy Americans are taxed more than middle-class Americans and middle-class Americans are taxed at a higher rate than working-class Americans.
A regressive tax is one that is not progressive. This could either mean that the tax is lower for wealthy individuals or that the tax is flat (everyone pays the same rate). Why is a flat tax regressive? People with lower incomes would feel the effect of a flat tax more strongly than people with higher incomes. To a multi-millionaire, a 15% tax wouldn’t translate to a substantial decrease in quality of life. To someone making $30,000 a year, a 15% tax would mean a serious dent in spending power.
A proportional tax is the same as a flat tax. Taxpayers at all income levels would pay the same “proportion” in taxes. As explained above, proportional taxes are regressive taxes. These types of taxes are common in state-level sales taxes but not common at the federal level. Anyone who remembers the 2012 presidential campaign will remember a famous proportional tax proposal, the 9-9-9 Plan. That plan was for a 9% business transaction tax, a 9% personal income tax and a 9% federal sales tax.
VAT or Ad Valorem Tax
The VAT tax is big in Europe but the U.S. has yet to adopt it. It’s a tax on the “added value” of a product, the difference between the sales price and the cost of producing a good or service. It’s a form of consumption tax that buyers pay when they make a purchase, similar to a sales tax.
So what’s the difference between sales tax and VAT? Sales tax is paid by the purchaser of a product. Only that final stage in the product’s life is subject to taxation. VAT, in contrast, is applied at each stage of the supply chain and then snowballed into the final purchase price. If you travel to a country with VAT you probably won’t notice you’re paying it because it is included in the prices you pay. Sales tax, on the other hand, is listed separately on receipts.
Property taxes are taxes you pay on homes, land or commercial real estate. If you’re deciding whether you can afford to buy a home, you should take property taxes into account. Unlike a mortgage, property tax payments don’t amortize. You have to keep paying them for as long as you live in a home – unless you qualify for property tax exemptions for seniors, veterans or disabled residents.
Capital Gains Taxes
Capital gains taxes apply to investment income after an investment is sold and a capital gain is realized. Because so many Americans don’t invest at all, they don’t pay capital gains taxes. There are also taxes on dividends and interests stemming from simple interest from a bank account or dividends and earnings from investments.
Estate and inheritance taxes are paid after someone dies. An estate tax is paid from the net worth of the deceased. It’s a tax on the privilege of passing on assets to heirs. There is a federal estate tax, and some states levy their own estate taxes as well. Inheritance taxes don’t exist at the federal level and are only law in a handful of states. They’re taxes on the privilege of inheriting assets, and so are paid by the heir, not the estate of the deceased.
If you take your annual salary and divide it by the number of times you get paid each year, chances are that number is higher than your actual paycheck. One reason could be that your healthcare premiums or 401(k) contributions are deducted from your paycheck. Another reason is payroll taxes. These taxes cover your contributions to Medicare, Social Security, disability and survivor benefits and to federal unemployment benefits. You’ll also have federal (and maybe state and local) income taxes withheld from your paycheck. You can learn all about payroll taxes here.
Income taxes do what the name implies. They tax the income you earn. Federal income taxes are both progressive and marginal. Marginal means that there are different tax rates for different income brackets. The top earners pay a high tax rate, but only on the amount of money they have in that top bracket.
So if you’re paying taxes for 2018 and you have $50,000 of taxable income, you will pay 10% on the first $9,525, 12% on your income between $9,525 and $38,700 ($29,175 of your $50,000) and then you will pay 22% on income between $38,701 and $50,000 ($11,300 of your $50,000). Since the highest income bracket for you has a rate of 22%, you would say that you’re in the 22% bracket. However, that doesn’t mean the government taxes all your income at 22%
The income tax brackets and rates for 2018 are different from previous years because of the new tax plan passed in late 2017. To understand how these new tax rates will affect your taxes, check out our article on Trump’s tax plan and how it will affect you.
There are many types of taxes in the U.S., and because taxes are here to stay, it’s nice to understand exactly the different types work. If paying taxes is a consistent source of stress for you, you may want to change your approach. That could mean starting earlier, using different tax preparation software or enlisting professional help, like a financial advisor with tax expertise.
SmartAsset’s financial advisor matching tool makes it easy to find an advisor. Simply answer a series of questions about your situation and your goals, and you’ll be matched with up to three advisors who meet your needs. You can read their profiles to learn more about them, interview them on the phone or in person and choose who to work with.
Tips for Saving Money
- Having a monthly budget can help you avoid overspending. Factoring taxes, like income and property taxes, into your budget can also help you plan your spending throughout the year. If you need help getting started, here’s a step-by-step guide on how to make a budget.
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