Income tax, capital gains tax, sales tax, property tax: It seems as if whenever financial matters are involved, there are taxes to contend with. And whether you’re new to the workforce or a seasoned retiree doing some estate planning, taxes can be complicated. With terms like “tax brackets” and “deductions,” or the differences between income vs. payroll taxes, you’re joining hundreds of millions of Americans who have had to figure out the confusing world of the U.S. tax code.
For individuals, taxes can have a profound effect on your life, influencing decisions on marriage, employment, buying a home, investing, healthcare, charity, retiring, and leaving a will. Therefore, even if you have a smart accountant, it’s important to get up to speed on the tax code.
In this guide, you’ll learn more about what taxes are and the different types of taxes to know, as well as some helpful tax filing ideas. Read on to raise your tax I.Q.
What Are Taxes?
At a high level, taxes are involuntary fees imposed on individuals or corporations by a government entity. The collected fees are used to fund a range of government activities, including but not limited to schools, maintaining roads, health programs, as well as defense measures.
Different Types of Taxes to Know
Here’s a detailed look at what are many of the different types of taxes that can be levied and the ways in which they’re typically calculated and imposed.
Income Tax
The federal government collects income tax from people and businesses, based upon the amount of money that was earned during a particular year. There can also be other income taxes levied, such as state or local ones. Specifics of how to calculate this type of tax can change as tax laws do.
In the U.S., the Internal Revenue Service processed 260+ million tax returns for the 2021 fiscal year. The amount of income tax owed will depend upon the person’s tax bracket and it will typically go up as a person’s income does. That’s because, in the U.S., there is a progressive tax system for federal income tax, meaning individuals who earn more are taxed more.
If you’re wondering “What tax bracket am I in?” know that there are currently seven different federal tax brackets. The amount owed will also depend on filing categories like single; head of household; married, filing jointly; and married, filing separately.
Deductions and credits can help to lower the amount of income tax owed. And if a federal or state government charges you more than you actually owed, you’ll receive a tax refund.
SoFi’s Income Tax Help Center
SoFi’s tax season 2023 Help Center includes information about how to prepare for a meeting with an accountant, how to file your taxes, what the various IRS forms are, and much more.
Property Tax
Property taxes are charged by local governments and are one of the costs associated with owning a home.
The amount owed varies by location and is calculated as a percentage of a property’s value. The funds typically help to fund the local government, as well as public schools, libraries, public works, parks, and so forth.
Property taxes are considered to be an ad valorem tax, which means they are based on the assessed value of the property.
Payroll Tax
Employers withhold a percentage of money from employees’ pay and then forward those funds to the government. The amount being withheld will vary, based on a particular employee’s wages, with federal payroll taxes being used to fund Medicare and Social Security.
There are limits on the portion of income that would be taxed. For example, in 2022, a person’s income that exceeds $147,000 is not subject to a common payroll deduction, Social Security tax.
Because this tax is applied uniformly, rather than based on income throughout the system, payroll taxes are considered to be a regressive tax.
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Inheritance/Estate Tax
These are actually two different types of taxes. The first — the inheritance tax — can apply in certain states when someone inherits money or property from a deceased person’s estate. The beneficiary would be responsible for paying this tax if they live in one of several different states where this tax exists and the inheritance is large enough.
The federal government does not have an inheritance tax. Instead, there is a federal estate tax that is calculated on the deceased person’s money and property. It’s typically paid out from the assets of the deceased before anything is distributed to their beneficiaries.
There can be exemptions to these taxes and, in general, people who inherit from someone they aren’t related to can anticipate higher rates of tax.
Regressive, Progressive, and Proportional Taxes
These are the three main categories of tax structures in the U.S. (two of which have already been mentioned above). Here are definitions that include how they impact people with varying levels of income.
What’s a Regressive Tax?
Because a regressive tax is uniformly applied, regardless of income, it takes a bigger percentage from people who earn less and a smaller percentage from people who earn more.
As a high-level example, a $500 tax would be 1% of someone’s income if they earned $50,000; it would only be half of one percent if someone earned $100,000, and so on. Examples of regressive taxes include state sales taxes and user fees.
What’s a Progressive Tax?
A progressive tax works differently, with people who are earning more money having a higher rate of taxation. In other words, this tax (such as an income tax) is based on income.
This system is designed to allow people who have a lower income to have enough money for cost of living expenses.
What’s Proportional Tax?
A proportional tax is another way of saying “flat tax.” No matter what someone’s income might be, they would pay the same proportion. This is a form of a regressive tax and proportional taxes are more common at the state level and less common at the federal level.
Capital Gains Tax
Next up, take a closer look at the capital gains tax that an investor may be responsible for paying when having stocks in an investment portfolio. This can happen, for example, if they sell a stock that has appreciated in value over the purchase price.
The difference in the increased value from purchase to sale is called “capital gains” and, typically, there would be a capital gains tax levied.
An exception can be when an investor sells increased-in-value stocks through a tax-deferred retirement investment inside of the account. Meanwhile, dividends are taxed as income, not as capital gains.
It’s also important for investors to know the difference between short-term and long-term capital gains taxes. In the U.S. tax code, short-term is one year or less, while long-term is anything longer. For tax year 2022, the federal tax rate on gains made by short-term investments are taxed as ordinary income. For long-term investment gains, the rates will be 0%, 15%, or 20%, based on filing status and taxable income.
Recommended: Capital Gains Tax Guide
Ideas For Tax-Efficient Investing
Ideas for tax-efficient investing can include to select certain investment vehicles, such as:
• Exchange-traded funds (ETFs): These are baskets of securities that trade like a stock. They can be tax-efficient because they typically track an underlying index, meaning that while they allow investors to have broad exposure, individual securities are bought and sold less frequently, creating fewer events that will likely result in capital gains taxes.
• Index mutual funds: These tend to be more tax efficient than actively managed funds for reasons similar to ETFs.
• Treasury bonds: There are no state income taxes levied on earned interest.
• Municipal bonds: Interest, in general, is exempted from federal taxes; if the investor lives within the municipality where these local government bonds are issued, they can typically be exempt from state and local taxes, as well.
VAT Consumption Tax
In the U.S., we pay a regressive form of tax, a sales tax, on many items that are purchased. In Europe, the system works differently. A VAT tax is a form of consumption tax that’s due upon a purchase, calculated on the difference between the sales price and what it cost to create that product or service. In other words, it’s based on the item’s added value.
Here’s one big difference between a sales tax and a VAT tax: The first is charged at the final part of the sales transaction. VAT, on the other hand, is calculated throughout each supply chain step and then built into the final purchase price.
This leads to another difference. Sales taxes are added onto the purchase price that’s listed; VAT contains those fees within the price and so nothing extra is added onto the price tag that a buyer would see.
Sales Tax
Ka-ching! You are probably used to sales tax being added to many of your purchases. It’s a method that governments use to collect revenue from citizens, and in America, it can vary by state and local area. For example, in 2023, in New York, the sales tax ranges from 7% to 8.875%, depending on where in the state you are.
Funds collected via sales tax are frequently used for local and state budget items. These might include school, road, and fire department expenses.
Excise Tax
An excise tax is one that is applied to a specific item or activity. Some common examples are the taxes added to alcoholic beverages, amusement/betting pursuits, cigarettes (yes, the “sin taxes,” as they are sometimes called, gasoline, and insurance premiums.
These taxes are primarily paid by businesses but are sometimes passed along to consumers, who may or may not be aware that these taxes can be rolled into retail prices. Some excise taxes, however, are paid directly by consumers, such as property taxes and certain taxes on retirement accounts.
Luxury Tax
Luxury tax is just what it sounds like: tax on purchases that aren’t necessities but are pricey purchases. It can be paid by a business and possibly passed along to the consumer. Typical examples of items that are subject to a luxury tax include expensive boats, airplanes, cars, and jewelry.
The revenue that’s raised by these taxes may fund an array of government programs designed to benefit U.S. citizens.
Corporate Tax
Here’s another tax with a name that tells the story. Corporate tax is, quite simply, a tax on a corporation’s profits, or taxable income. This is based on a business’ revenue once a variety of expenses are subtracted, such as administrative expenses, the cost of any goods sold, marketing and selling costs, research and development expenses, and other related and operating costs.
Corporate taxes are specific to each country, with some having higher rates than others, and there are a variety of ways to lower them via loopholes, subsidies, and deductions.
Tariffs
Tariffs represent a protectionist tool that governments may use. That is, they are taxes levied on imported goods at the border. The idea is typically that this will help boost the cost of imports and hopefully nudge consumers to buy items made on home soil.
Surtax
A surtax is an additional tax levied by the government in addition to other taxes. It is typically paid by consumers when the government needs to raise funds for a specific program. For instance, a 10% surtax was levied on individual and corporate income by the Johnson administration in 1968. The funds were collected to help fund the war effort in Vietnam.
Tax-Filing Ideas
Now that you know what are the different types of taxes, consider the event that makes many of us contemplate this topic: filing taxes. It’s an annual ritual that may trigger anxiety for many, but if you spend a little time educating yourself about the process, it’s not so scary. Here, a few ways to help make preparing for tax season easier:
• Consider how you’d like to file. Choose the method that best suits your needs and comfort level. You might want to work with a professional tax preparer to assist you, or perhaps use tax software to help you through the process. Another option is to fill out either the IRS form 1040 or 1040-SR by hand and mail it in, but given how this can open you up to human error and handwriting or typing mistakes, it’s not recommended.
• Gather all your paperwork. Being organized can be half the battle here. Develop a system that works for you (you might want to use a tax-preparation checklist) to collect such items as:
◦ Your W-2s and/or 1099 forms reflecting your income
◦ Proof of any mortgage interest paid or property taxes
◦ Retirement account contributions
◦ Interest earned on investments or money held in bank accounts
◦ State and local taxes paid
◦ Donations to charities
◦ Educational expenses
◦ Medical bills that were not reimbursed
• Even if you are lower-income and don’t need to file, consider doing so. It may be to your financial benefit. For instance, you might qualify for certain tax breaks, such as the earned income tax credit or, if you’re a parent, the child credit .
• Whether you owe money or are getting a refund, know how to settle your account with the IRS. If you’ll be receiving a tax refund, you may want to request that it be sent via direct deposit to make the process as seamless and speedy as possible. If, on the other hand, you owe money, there are an array of ways to send funds, including payment plans. Do a little research to see what suits you best.
By getting ahead of tax-filing deadlines in these ways, you can likely make this annual ritual a little less intimidating and time-consuming.
Recommended: Guide to Filing Taxes for the First Time
The Takeaway
Understanding the different kinds of taxes can help you boost your financial literacy and your ability to budget well. You’ll know a bit more about why you pay federal and any state and local taxes, and also be aware of charges like luxury taxes and sales taxes.
Here’s another way to help your finances along: by partnering with a bank that puts you first. At SoFi, we pride ourselves on giving you the tools you need to manage your money well. For instance, with our Checking and Savings account, you’ll be able to spend and save in one convenient place, take advantage of automatic savings features, and, for qualifying accounts with direct deposit, get paycheck access up to two days early. All that, plus a competitive interest rate and no account fees!
FAQ
What are the most common taxes people use?
The most common taxes that Americans pay are income tax on their hard-earned money, sales tax on purchases, and property tax on their homes.
How many categories of taxes are there?
There are easily more than a dozen kinds of taxes levied in the U.S. Which ones you are liable for will depend on a variety of factors, such as whether you are an individual or represent a business, whether you purchase luxury items, and so forth.
Will I use all of these forms of taxes?
Which forms of taxes you will be liable for will likely depend upon the specifics of your situation. For example, among the most common taxes are income, property, and sales taxes, but if you rent rather than own your home, you won’t owe property taxes. If you purchase a boat, you might pay a luxury tax; if you like to frequent casinos, you could be paying excise taxes.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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