Like it or not, everyone has to pay the tax man. It’s important to know what types of taxes you may owe the government come tax time, lest you end up owing the IRS more than you’re prepared for.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. Tax situations can be very complex and laws vary by region. It may be wise to consider the help of an industry professional when it comes to tax-related decisions.
If you don’t yet have industry professionals handling your portfolio, we can help! Check out Financial Professional’s investment marketplace, where we partner with some of the best in the business to help find the right investment for you.
Three Main Types of Taxes
There are many different types of taxes in the Unites States. We’ll start with the basic taxes that you may already know. However, before we get into the specifics, let’s discuss the three main types:
- Progressive Taxes: This type of taxation refers to taxes that increase based on the amount of income that is subject to taxes. This is related to income taxes. When your income progresses, so do your taxes; hence the term “progressive.”
- Regressive Taxes: This type of tax is the opposite of a progressive tax. The more income you have that is subject to tax, the less tax you have to pay. This refers to social security and payroll taxes, which we will cover later.
- Flat Taxes (Proportional Taxes): This is a flat rate tax, such as state tax.
Taxes from Your Earnings and Income
There are several ways to divide your taxes. Here, we’ll discuss types of taxes related to employer or work-related income, as well as other earnings-based taxes.
Federal Income Taxes: Income tax is the tax on your earnings, wages, and income. There are several marginal tax rates, as shown above in Figure 3.1. Typically, income tax is taken from your paycheck if you work as a W-2 employee. Ideally, you want to pay the exact amount you owe. However, most people overpay through the year, which is why we have tax return season at the end of the accounting fiscal year.
Self-Employment Taxes: Just like your employer, if you are working for yourself, you have to pay self-employment tax. This is a type of tax small business owners, freelancers, and contractors must pay to the United States government to fund Medicare and Social Security. If your income or net earnings over the course of one year come out to more than $400, you will be subject to self-employment tax. Typically, self-employers are required to pay their estimated taxes quarterly.
State & Local Income Taxes: These are just like federal income tax, but levied and paid to the state in which income is earned. Some states do not have income tax, such as Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. There are also nine states that have a flat tax rate: Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, North Carolina, Pennsylvania, and Utah. Some cities and counties also collect taxes, depending on your location.
FICA & Payroll Taxes: Employers remove a certain amount for FICA & payroll taxes from your paycheck and send it to the appropriate government agency. As previously mentioned, if you’re self-employed, you may have to estimate and pay this quarterly as well. Social Security and Medicare is also another tax in this category. The rates for their taxes depend on your income, although some are flat taxes.
Income Taxes from Non-Employer Sources
Inheritance Taxes: Inheritance is what gets passed on to you when someone else dies. Depending on how much you inherited, you may have to pay a certain amount of tax on it, depending on your relationship to the deceased. Currently, only six states collect inheritance taxes.
Estate Taxes: This applies to money you pass on after you die. Essentially, it’s a tax on your life’s net worth and legacy. The federal government collects estate taxes, as do 12 states and Washington D.C. Your estate pays the tax depending on how much you leave behind.
Capital Gains Taxes: A capital gain is a rise in the value of any capital asset that is worth higher than the price it was bought. For instance, if you buy Stock A at $5 per share and sell it for $10 per share, then you will be required to pay capital gains tax on your $5 per share gain. Unrealized capital gains are the profits that are shown on paper, while the actual transaction (sale) hasn’t occurred. A capital gain is realized when the asset is sold. There are both long term capital gains taxes (for assets held over one year), and short-term capital gains taxes (assets held less than a year).
Ad Valorem Taxes
Or, in other words, a property tax.
Ad valorem taxes are essentially a type of tax based on the value of a good or property. When you buy a home, along with homeowners’ insurance and your mortgage, you have to pay property taxes. The rate you pay depends on the value of your home and the location in which you live.
There are two basic types of consumption taxes:
- Sales Taxes: This applies to what you buy and is collected at the point of sale. For instance, if you see an item on a store shelf for $1.00, but pay $1.06 at the register, you have just paid 6% in sales taxes on your item. The exact tax rate is determined by the state in which you live.
- Value-Added Taxes (VAT): This type of tax applies to goods you purchase. It’s similar to sales tax, except it’s applied to every step in the production process as the value of the item increases during every step of production. The price you see in store already includes the VAT, so most people don’t have to worry about this tax.
Other Types of Taxes
Business Taxes: Along with individual income taxes, as a business owner you may have to pay a business tax rate based on your revenue. This tax applies to a company’s profits (revenue minus expenses).
Tariffs: This is a type of tax levied on goods that cross international borders. The country importing the good collects the tariff. The current trade war is a battle of imposed tariffs between U.S. and China.
A deduction lowers a person’s tax liability by decreasing taxable income. This, in turn, may lower your tax rate. Note that a deduction does not decrease the amount of tax you owe; rather, it indirectly lowers your taxes by first lowering your income.
There are two main types of deductions to consider when you file your taxes:
- The Standard Deduction is a standard amount set by the IRS. Typically, most people can deduct this amount from their total income to lower taxable income. While this is the easiest choice to make as it requires no effort, it may not be the best choice.
- Itemized Deductions allow you to account for expenses and charitable contributions that exceed the standard deduction. Going through and itemizing your deductions can be a lot of work if you don’t have a tax professional do it for you – but this method can drastically decrease taxable income.
Whichever method you choose, be sure to take at least one – either will help decrease your tax bill. If you’re unsure how to proceed come tax time, ask your accountant how you can take a deduction based on your personal situation.
Let’s See an Example of Each Deduction
Mike and Jim are two single men. Each makes $85,000 per year working for a sales firm and have no other income (they really should start investing, though). Mike and Jim each own a home and make generous charitable contributions of $15,000 per year.
Come tax time in 2018, Mike and Jim each do their own taxes. Mike taxes his time and itemizes all of his deductions. Jim, on the other hand, is in a hurry and just takes the standard deduction.
Mike’s taxable income decreases by a total of $15,000 in charitable contributions, before even considering mortgage loan interest and other expenses. Therefore, his itemized deductions bring his taxable income to less than $70,000.
Because the standard deduction is set at $12,000 in 2018, Jim’s taxable income decreases to $73,000. Just by discounting the itemized deduction option, Jim cheats himself out of $3,000 of eligible deductions, thereby increasing his tax bill inadvertently.
A Final Word of Types of Taxes
There are many different types of taxes everyone should be aware of. Unfortunately, the salary your employer says they’ll pay you isn’t what actually ends up in your pocket, as a large portion of your paycheck goes to various taxes (as well as other expenses, such as insurance and 401k/Roth IRA plans).
You should always take as many deductions as you can to save the most amount of money come tax time.
Furthermore, you’ll do well to stay educated about finances. As always, Financial Professional is here to help!