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Understanding How Your Taxes Work


Schools, roads, parks, hospitals, and other public works and services rely on you and your neighbors, businesses, organizations, and estates to pay taxes that will help fund their budgets. Understanding how taxation works can give you a big-picture idea about the ways your money gets taxed and empower you to take greater control of your finances. A financial advisor can also help you align your tax strategies to reach your financial goals.

What Are Taxes?

Taxes are money collected by the government to fund government operations. Before the income tax, the US government mostly funded its operations with import taxes known as tariffs.

These days, Americans pay many types of taxes. They include income taxes, property taxes, sales taxes, sin or excise taxes, capital gains taxes, and estate taxes. People disagree about how high taxes should be. Some say that when taxes are too high the economy can’t grow. Others argue that robust taxation helps distribute income and provide for the common good.

One of the aspects of taxation that’s hard for some people to accept is that pretty much everyone pays for something they don’t use, and a lot of us pay for things that we don’t like. For example, your taxes may help fund public schools that your kids don’t go to or policies you don’t agree with. That – and the bite taxes take out of our budgets – is part of why raising taxes can be a tough sell politically.

Unless you don’t work or you work under the table, you prepay part of your tax bill throughout the year through payroll taxes. Payroll taxes deduct tax money from your paycheck and from your employer’s coffers to help pre-pay your income taxes and to pay your Social Security and Medicare taxes.

Your pre-tax earnings get reduced by approximately 30% before they hit your bank account, which is why post-tax earnings are always lower than the salary you negotiated with your boss when you decided to take the job. That is why it’s important to know the difference between pre-tax and post-tax dollars. SmartAsset can help you figure out how much you will earn after taxes with our paycheck calculator.

Direct Taxes

Understanding Taxes

The definition of a direct tax is a tax that is paid straight from the individual or business to the government body that imposes the tax. Examples of direct taxes include individual income taxes (paid to the federal and state governments), corporate taxes (paid on an organization’s profits), and property taxes (paid on the value of real estate).

The federal income tax almost didn’t make it into law because the Supreme Court initially objected to the fact that it was a direct tax, rather than being apportioned among the states based on population. The 16th Amendment to the Constitution overrode the Supreme Court’s ruling in 1913 and the direct income tax was born. Direct taxes are based on a percentage of the value of what is being taxed, and they are set by state and federal law.

Indirect Taxes

Indirect taxes are typically added on transactions for goods and services like imports, gas, alcohol and tobacco. They include sales taxes, value-added taxes, sin or excise taxes, and tariffs. These taxes are considered indirect because they do not flow straight from the payer to the government. For example, when you pay a sales tax you don’t pay that money to the government. The merchant who sells your goods pays the sales tax to the government.

Indirect taxes are in some sense hidden by definition. You pay a higher price for a flat-screen TV to account for the sales tax rather than writing the government a check for that sales tax amount. This kind of tax is also known as an indirect business tax.

Unlike direct taxes, indirect taxes are imposed at the same rate for each transaction, without taking into account the wealth of the person. Critics say this is unfair because it taxes the income of a poorer person more than a wealthier one.

Tax Expenditures

Understanding Taxes

Tax expenditures are defined by the law as “revenue losses” from special tax code provisions that can help taxpayers lower taxes. Examples of these include tax deductions and tax credits. The government can choose to forgo tax revenue to provide financial assistance to different groups of taxpayers and promote activities that could benefit the economy or a community, like buying a home or donating to charity.

A tax deduction reduces your taxable income. As a result, you pay lower taxes. The higher your tax bracket (the percentage of the income that you owe in taxes) the more valuable a tax deduction is. As an example, a $500 tax deduction is worth much more to someone in the 35% tax bracket than someone in the 15% tax bracket because 35% of $500 ($175) is more than 15% of $500 ($75).

Tax credits reduce the money you owe in taxes rather than reducing your taxable income. A $500 tax credit means you owe 500 fewer dollars to the IRS. Tax credits come in two forms, refundable and non-refundable.

This means that if your total tax liability (what you owe to the government) is $800, and you get a $1,000 non-refundable tax credit, your $800 tax liability would be canceled out but you wouldn’t be able to keep the remaining the $200 ($1,000 – $800). With a $1,000 refundable tax credit you would get those $200 from the government.

Bottom Line

You can’t avoid paying taxes. However, understanding how taxes work can empower you to make smart choices about managing your finances and getting the highest net income. A good tax plan can set up your personal finances strategically to take advantage of different tax breaks and tax credits. And this could help reduce how much you owe in taxes.

Tax Planning Tips

  • Taxes can be complicated. You want to make sure you’re getting every deduction and credit you are entitled to. That’s where a financial advisor can be invaluable. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • A financial advisor can help lower your taxes. One strategy could be to harvest your losses. This means that you will be able to use your investment losses to offset the income that you made from other investments.
  • Figuring out your taxes doesn’t have to be complicated. SmartAsset’s income tax calculators will help you calculate federal, state, and local taxes.

Photo credit: © iStock/k_woodard, © iStock/Marilyn Nieves, © iStock/Skyhobo