Your fundamental tax questions, answered
To paraphrase Benjamin Franklin, there are two certainties in life: death and taxes. While taxes may be a contentious political issue for some or a tedious annoyance for others, they are an integral part of modern society, providing many of the public goods and services we use on a daily basis.
Grasping the concept of taxes can be challenging, but it is crucial if you want a better understanding of your own finances as well as how the government spends your money.
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What are taxes?
Taxes are compulsory charges, fees, or payments imposed on individuals or organizations by a government. In the United States, taxpayer money is used to finance a wide range of projects, such as Social Security, national parks, the defense budget, and highways, to name a few.
Various forms of taxes are collected by different levels of government, ranging from local county governments to the federal government. Common taxes include sales tax, income tax, property tax, excise tax, and tariffs.
Sales tax and value-added tax
Sales tax is a tax imposed on goods when they are sold to the final customer. In some countries, a value-added tax (VAT) is added to a product at each stage of the sales process. Both taxes are typically calculated as a percentage of the product’s price, but they can also be a fixed fee added to the total cost.
Income tax and progressive tax systems
Income tax is a percentage of the money you earn on each paycheck. In the United States, taxable income is taxed at different rates depending on the amount earned. These brackets change, with the tax rate increasing with income. Tax brackets and rates are subject to change, so you should refer to the most recent information from the IRS for current figures.
Property tax, wealth Tax, and excise tax
Property taxes are levied on property, such as houses, and can be charged regularly or during transfers. Some countries impose wealth taxes on a person’s entire net worth. Excise taxes are applied to goods during the manufacturing process and are typically passed on to the customer in the form of higher prices.
Tariffs are fees charged for importing or exporting goods, which often result in higher prices as the payer passes the cost along.
Why do we pay taxes?
Taxes primarily finance government activities. Everything from paved roads, snow plows, bridges, and jury compensation requires funding. While governments can borrow money for short-term financing, they must demonstrate the ability to repay the debt, which usually comes from tax revenue.
Taxes can also serve other purposes, such as protecting domestic industries through high tariffs or discouraging the consumption of harmful substances by imposing special taxes on items like tobacco and alcohol.
Furthermore, taxes address the free-rider problem in economics and social science. Many government-provided services, such as libraries and parks, lack direct fees. Taxes ensure that everyone can use these services “for free,” as the funding for their maintenance comes from tax revenue.
The history of taxes
Complaining about taxes places you in a long-standing tradition. The history of taxes spans thousands of years, with various civilizations implementing their own taxation methods to support public services and infrastructure.
The first known taxation system was in Ancient Egypt’s First Dynasty, around 3000 BCE. Those unable to pay their tithe contributed labor to the state. The story of Joseph in the Bible mentions a 20% tax rate on all grain produced in Egypt.
The Persian Empire, under Darius I, established a tax system requiring each province to contribute based on its wealth and resources. India supplied gold, while Egypt mainly provided grain. In Ancient Rome, the Roman Republic had a low property tax, with the Roman Empire later taxing provinces based on wealth and population.
During the Middle Ages, feudal lords imposed taxes on their subjects in various forms, such as labor, goods, or money. The Magna Carta, signed in 1215, restricted the English king’s ability to levy taxes without the nobility’s consent.
In modern history, the development of nation-states led to more structured tax systems. Some of these systems sparked revolts. The United States, for example, emerged after the American colonies revolted against Britain over disputes about taxation without representation. Post-war financial challenges prompted the creation of the first federal taxes. The 16th Amendment to the U.S. Constitution, ratified in 1913, granted Congress the power to levy an income tax, which remains a primary source of government revenue today.
How to pay your taxes
Navigating the process of paying taxes in the United States can be confusing for many individuals. Here are some essential aspects to consider when it comes to paying your taxes.
Withholding taxes from your paycheck
In the United States, most full-time workers have taxes withheld from their paychecks. This withholding includes federal income tax, Social Security tax, and Medicare tax. Some states and localities also require withholding for state and local income taxes. Your employer calculates the amount of tax to withhold based on the information you provide on your Form W-4, which you typically complete when you start a job.
Filing your tax return
Each year, between January 1 and April 15 (or the following business day if April 15 falls on a weekend or holiday), you are required to file your tax return with the federal government and, if applicable, your state government. The tax return is a summary of your income, deductions, credits, and taxes paid throughout the year. This process ensures you have paid the correct amount of income tax. If you overpaid, you may be eligible for a refund, whereas if you underpaid, you will need to pay the remaining balance.
When filing your tax return, it’s important to understand the difference between gross income and adjusted gross income (AGI). Gross income is your total earnings before any taxes or deductions, while AGI is your gross income minus certain adjustments, such as contributions to an IRA or student loan interest. To calculate your income tax, you’ll use your taxable income, which is derived from your AGI after accounting for deductions and exemptions. Understanding these distinctions helps ensure you pay the correct amount of taxes.
Choosing a filing method
There are several methods to file your tax return, including online filing through the Internal Revenue Service’s (IRS) Free File program or using tax preparation software, mailing a paper return, or employing a tax professional. Each method has its advantages and disadvantages, so it is crucial to select the one that best suits your needs and financial situation.
Managing your withholding
You can control the amount withheld from your paycheck by adjusting your Form W-4. Some people prefer to have more tax withheld throughout the year and receive a larger refund later. Others may choose to withhold only the exact amount they owe each payday and handle any additional taxes at tax time. Both approaches have their benefits, and the best choice depends on your individual financial goals and preferences.
Estimated tax payments
If you are self-employed or have income from sources other than a regular salary, you may need to make estimated tax payments throughout the year. These payments are typically made quarterly and are designed to cover your income tax, as well as self-employment tax, if applicable. Failing to make these payments can result in penalties and interest.
Paying taxes in the United States can be a complex process, but understanding the various components and options available can help you manage your finances effectively. While taxes may not be enjoyable, they are a necessary part of our society, and comprehending them is crucial for financial success and contributing to the shared resources we all rely on.