Understanding How Your Taxes Work

Taxes paid by individuals, businesses, organizations and estates help fund schools, roads, parks, hospitals and other public services. Knowing how taxation works can give you a big-picture idea about the ways your money gets taxed and position you to take greater control of your finances. A financial advisor who specializes in tax planning can also help optimize your finances for tax-efficiency.

What Are Taxes?

Taxes are money collected to fund government operations and public services. Before income taxes were introduced, the U.S. government relied mainly on import taxes, called tariffs, to raise revenue.

Today, Americans pay several types of taxes, including income, property, sales, excise, capital gains and estate taxes. Opinions about taxes vary—some believe high taxes slow economic growth, while others think taxes help distribute income and fund programs for the common good.

Taxes often pay for services or programs that individuals may not use or agree with. For example, your taxes might support public schools even if you don’t have children or fund policies you oppose. This is one reason raising taxes can be politically challenging.

Most workers prepay part of their tax bill through payroll taxes. These deductions come out of paychecks and are used to cover income taxes, Social Security and Medicare contributions throughout the year.

Pre-tax earnings are reduced by about 30% before reaching your bank account, which is why post-tax income is lower than your agreed salary. Understanding the difference between pre-tax and post-tax income can help with financial planning. Tools like SmartAsset’s paycheck calculator can estimate your take-home pay after taxes.

Direct 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

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 directly reduce the amount of taxes you owe, rather than lowering your taxable income. A $500 tax credit reduces your tax bill by $500. Tax credits can be refundable or non-refundable, depending on whether you can receive money back if the credit exceeds what you owe.

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 $200 ($1,000 – $800). With a $1,000 refundable tax credit you would get those $200 from the government.

Bottom Line

Taxes are unavoidable, but understanding how they work can help you manage your finances and maximize your income. A 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.

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