Is there anything Americans enjoy more than taxes?
Each year, we get to deduct money from our paycheck, and then come spring we get to compile W2s and 1099’s from each place we worked and carefully calculate numbers and withholdings, along with deductions. We get to think back on business purchases we made, and find enough receipts to help prove what we can write off. We then get to file and hope we don’t get an audit. And if we do get an audit, we hope it’s just a bureaucratic mistake at the IRS. If we’re lucky, we’ll get a nice refund. If we’re not, we end up owing more money.
This is, of course, an extremely simple and reductive narrative of taxes. The truth is much more complex (and complicated). For one, taxes go to funding the goods and services we use from the government. As much as it can hurt seeing money deducted from each paycheck, we enjoy roads and infrastructure. It’s nice to have schools and public services. For those of us not yet retired, seeing social security deductions can hurt too. But once retired, it becomes less of a burden and more of a boon.
In short, despite our generally negative cultural perception of taxes, they serve a use. Despite the headaches and heartaches they can give us, it isn’t without good cause. And when we hear [legal] loopholes, what we really mean are strategies not outlined in the tax code that provide legal ways to help save money and be smart about what we pay.
Taxes are, I’m forced to say, is a necessary evil. And despite the simplification, there is a great range of taxes with different applications to different people and institutions. A single individual without a business won’t pay corporate taxes, for instance. If you don’t leave anything behind in your will to heirs, then you won’t have to worry about estate taxes.
It’s essential to demystify the different types of taxes and how they’re levied and figured. Despite the complications of the US tax code, tax categories themselves are rigid and fairly easy to understand on the face of them.
Most of us know the main differentiation between federal and state taxes. Federal taxes are collected for the US government, and state taxes are collected on a state-by-state basis. Sales and use tax are collected by state and local governments at different rates as well, depending on the location and the type of service or good. You pay both federal and state taxes each year to the IRS and your state tax authority. Sometimes, if you’re lucky, you get a refund from both.
Between federal and state taxes, there are five main types of common taxes in the United States:
- Income
- Property
- Capital gains
- Payroll
- Inheritance/estate
Income taxes are by far the best known. If you’ve ever worked a job, they’ve come up. Income taxes tax the income you earn at a fixed rate per earning bracket. Top earners pay more, for instance. Tax brackets can change over time as Congress enacts new tax laws, such as the 2017 tax law.
Property taxes are taxes you pay on property you own, such as homes, land, or commercial real estate. Many people often confuse property taxes with mortgages. The crucial difference is that you can pay off a mortgage and own your house one day; property taxes are levied every year regardless, which means you pay them as long as you own that property. There are certain property tax exemptions, such as for veterans, seniors, or the disabled. When buying property, a good strategy is to take property taxes into account.
Capital gains taxes have been enjoying some headlines recently, but what are they, exactly? Capital gains taxes are payable after you realize income from the sale of an investment property. For instance, if you sell stocks for more than you paid for it, you pay taxes on that gain, which can be classified as short term or long term, depending on how long you held the stock.
Payroll taxes cover your contributions to Social Security, Medicare, disability and survivor benefits, and federal unemployment benefits. Typically, these charges are all withheld from your paycheck.
The last major type is the inheritance or estate tax. You’ve probably seen these taxes in the news from time to time, often being pejoratively referred to as a “death tax”. While it is true that a death is what triggers an inheritance or estate tax, it isn’t a tax on the dead or expenses related to funerary costs. The federal estate tax is imposed on assets handed down to beneficiaries. An estate tax is based on the net worth of the deceased. Inheritance taxes are imposed under the laws of certain states. Inheriting assets is considered a privilege by the inheritance tax and is thus paid by the beneficiary rather than the deceased.
Of course, types of taxes aren’t the end of the situation. There are also various ways taxes themselves are figured and collected. With this, we can have:
- Consumption tax
- Progressive tax
- Regressive tax
- Proportional tax
A consumption tax is a tax on the money people spend rather than the money they earn. You’re undoubtedly aware of these, as you pay sales tax every time you’re in a store. Sales taxes also vary state by state and county by county. For certain ecommerce goods, you figure sales and use tax and file later on your own according to the county or state rate that’s applicable to the transaction. Certain goods, such as alcohol and gasoline, also have what is called an excise tax, which is a form of consumption tax.
In the US federal income tax system, we have a progressive tax. That means higher taxes are collected from those who earn more money. This is why and how we figure tax rate brackets based on income level. Very high earners pay more than middle-class or low-income earners. This idea shows up frequently in the news and in various tax plans proposed by politicians.
A regressive tax is simply any tax that is not progressive, such as a flat tax. This means the tax rate is the same across the board regardless of income or life circumstances. A wealthy individual who made $10 million would pay 15%, and a low-income earner who pulled in $30,000 would also pay 15%. While the idea sounds fair on the face of it, the fixed rate for both parties affects both differently. 15% of $10 million is a far smaller dent in earning power than 15% of $30,000.
A proportional tax is a specific form of flat tax such as the one mentioned above. Some proposed systems have fixed percentages across the board, such as 9% personal income tax and 9% federal sales tax and 9% business transaction tax, all equal for all across the board. So far, the US has not implemented this system, but proposals for it are very common and frequently show up in debates about changing the US tax code.
In Europe, there is also a VAT, or value-added tax. This is a tax on the added value of a good or service, or the difference between what it costs to produce the good or service versus the sales price. It’s a consumption tax based on purchase, much like a sales tax. VAT taxes are figured into prices for goods and services in Europe, so you’re not aware you’re paying it, unlike a sales tax where it’s listed separately on the receipt.
Businesses have their own types of taxes, such as corporate taxes and gross receipts taxes. Tangible personal property taxes are taxes on assets that can be moved or touched, like machinery, vehicles, furniture, and inventory. They’re most commonly levied on the assets of a business. Businesses and corporations also have different brackets and ways of being figured, which is too complicated a discussion for this blog.
So, with all this information about tax types and brackets and rates, what’s to be done? How does it affect the average person?
As you can see, that varies strongly. An individual with a business will have a very different tax outlook than one without. A person who makes very little income will pay far smaller taxes than, say, Jeff Bezos. A person’s tax rate, for instance in the tangible personal property category, will vary depending on how much they own. A business with high levels of inventory and assets will pay more than a business or service without those same assets. This can be an important consideration when starting a business and figuring how to break even.
When planning estates and wills, it’s a good call to consult a financial professional to help make the most of the inheritances and assets. You want your heirs to get as much of your estate as possible upon your death. There are various ways to distribute the funds and inheritance to fully capitalize on it without sacrificing large chunks. Money can be saved simply by being smart and taking steps to mitigate the distribution.
For a business, deductions versus earnings is a topic that also deserves its own blog. You want to keep careful, detailed books of your business expenses and your operating costs. You can write these off on your taxes and offset it against income and gains. For startups and young businesses, smart tax deduction strategies can be the difference between surviving and failing. With so many businesses failing in the first 18 months of their lives, a tax diversification should be considered. Factoring in business costs like marketing expenses also encourages allocated spending on resources that can help grow the business successfully.
As you can see, there is no shortage of scenarios involving taxes. From regular consumption taxes all the way up to complicated corporate taxes, rates and brackets and types and strategies are always at play. It can be terrifying to imagine dealing with the IRS and trying to do all this on your own. If you’re trying to start a business, it can be deeply discouraging to learn about tax rates and what to do.
But, just because the rules and regulations are expansive or labyrinthine doesn’t mean it can’t be navigated. One of the values of a financial professional is to help lay out a roadmap for your financial future. Taxes are a large part of that, and smart tax diversification strategies for making the most of your money can help you achieve your financial goals. No matter your goals, tax diversification can help mitigate losses. It is wise to seek advice from a professional tax advisor.
