What Are Taxes and Why Do We Pay Them?

“Nothing is guaranteed in life except death and taxes,” thats what people often say about paying taxes. Taxes are often seen like a certainty in life. An eternal component of our financial, commercial, and personal lives. Something that is present in every purchase and in every bank statement. Though taxes have become a seemingly permanent part of our lives, very few actually understand the basics of taxes or all the different types of taxes we are charged on a regular basis. It is an important part of our financial lives. Understanding what they are and why we pay them is a big step towards financial literacy and freedom.

Understanding Taxes

Taxes in their most simple form are involuntary (meaning required) fees that are charged to individuals or businesses and collected by a government or organization in order to fund larger activities. These taxes are charged to help fund a number of important activities, such as public works, government services, legislative officials, and maintaining internal infrastructures in businesses. Taxes are generally used for the greater good, meaning the money they provide goes back into helping the larger community through services, positions, or activities.

Who Pays Taxes?

Taxes are typically charged on certain types of monies or investments that are received by individuals or businesses that qualify as taxpayers. Not everyone pays taxes. Some people are exempt due to their age, income level, or disability status. However, the income that can qualify as taxable varies widely. It can be your salary or pay from your work, capital gains from investments, dividends on bank accounts or money markets, and even certain gifts or inheritances received from family members. In some states, you will also pay additional taxes on certain purchases you make, such as groceries, clothing, or alcoholic beverages.

Taxes are required, and you can go to jail for not paying all the taxes that you owe. The Internal Revenue Service (IRS) is in charge of collecting taxes and setting the tax rates for the upcoming year, in compliance with local, state, and federal laws. There are many different types of taxes that you as a taxpayer or business owner. Each of them is levied separately and for different reasons at different rates.

Income Tax

Income tax is the most common type of tax people encounter. It describes a tax generated automatically depending on the income you generate within a given year, either as a business owner or an individual. You will file an income tax return annually to help determine how much tax you will owe based on your income earned the previous year. Income tax is calculated on all forms of income, including wages, annual salary, sales commissions, investment earnings, and business profits.

Individual Income Tax

This type of personal income tax is paid only for individuals based on their unique income for the year. This is typically gathered by the state, not at a federal level. Your taxable income can be reduced by exemptions, deductions, and credits depending on your unique financial situation. This means that you will not pay tax on your entire income.

Calculating Income Tax

Your entire income is not taxable. Every taxpayer’s unique citation determines what exemptions, deductions, and credits you might be eligible to help reduce your overall taxable income. There are several common types of deductions based on your personal situation. Every taxpayer has the choice to opt for an itemized deduction (a line by line accounting of all the expenses and credits you’re eligible to receive) or a standard deduction (a flat fee that reduces your income by x amount and does not require individual accounting). For 2020, the standard deduction for a single person was $12,400, while a married couple filing jointly could deduct $24,800. As the head of a household, you’re eligible to deduct $18,650.

Itemized deductions are more specific. These include mortgage interest paid, local income, sales, and property taxes, medical expenses, work-related education expenses, and charitable donations; there are many other categories as well. Itemizing deductions can help you save some extra money depending on your financial situation, especially if your itemized deductions add up to more than the standard deduction.

Credits are applied based on if you’re claiming people as dependents (people in your household you take care of), how much money you’ve saved over the past year, your status as a homeowner, energy-efficient properties, health care coverage, and education or tuition tax credits.

Examples of how Income Tax are calculated

Let’s look at how these might play out for a real-life couple. For example, say that you’re a 40-year-old employee who makes $60,000 a year. You are the head of your household and file jointly with your spouse, who makes $40,000 a year. Both of you receive health insurance through your employers. You have donated $1,000 over the past year and live in your own home, you pay a monthly mortgage fee of $1,600. You have two twin children who are six years old.

 In this case, you and your spouse are starting with a combined annual income of $100,000 a year. Your itemized deductions will not exceed the standard deduction of $24,800, so you choose to take the standard deduction. Your taxable income is now $75,200. Based on this income, you will then be assigned a tax bracket (a range of incomes that you fall between), which comes with its own percentage of tax rate you’ll be asked to pay. In this case, your total tax due is $8,600. However, you’re eligible for a child tax credit for your two children, reducing your taxes due by $4,000 and leaving your total tax bill for approximately $4,600.

Freelance Tax

As a freelancer, the money you earn falls under additional income taxes. The IRS considers freelancers self-employed if they make more than $400 a year. You’ll need to pay not only your standard income taxes but an additional self-employment income tax because the IRS considers you a business owner. This may seem like an excessive charge, but it makes sense when you realize you are now accounting for both the employer and employee contributions to other federal tax programs.

Corporate Tax

Corporate taxes are taxes charged on the profits of a business or corporation. These taxes are paid based on the annual reported taxable income of a business. It’s calculated using the formula of total revenue earned minus cost of goods sold. Administrative expenses, sales and marketing, depreciation, and other general operating expenses are factored into the cost of doing business.

Corporate tax rates vary widely from location to location and can be altered or avoided through deductions, subsidies, and other tax loopholes created by certain states. Thus, the effective corporate tax rate (the rate of taxes actually paid) is usually far lower than the stated legal tax rate.

Sales Tax

Sales taxes are consumption taxes paid with the purchase of every good or service that’s consumed. The typical conventional sales tax is usually charged at the initial purchase of the item. The business collects your taxes and then pays them to the government; they are serving as the intermediary and making sure the government is paid appropriately for every purchase. There are loopholes to avoid paying certain taxes, and some states have very low or even non-existent sales taxes. Overall most states charge them as a way to fund other activities. Sales tax is typically higher on luxury items or restricted items such as alcohol or imported goods.

Property Tax

Property taxes are paid on property owned by individuals or entities directly to the government. It’s calculated based on the land value and any structures located on the land at the time and is charged annually by local governments to the owners of the property at hand. Some places even tax personal property such as cars or boats in addition to land.

Tariffs

Also known as international taxes, tariffs are charged specifically on imported goods that are designed to discourage people from buying internationally and stick to local products. Tariffs are charged on any product shipping in from outside the United States. They are usually much higher than other taxes. They’re also often charged in addition to other local or state taxes, adding to the overall expense of your purchase.

Estate Taxes

Estate taxes are paid at the time of a person’s death based on the total value of their property. Many estates use legal loopholes or careful writing of their inheritances to avoid these taxes. Estate tax rates are often high and can significantly decrease the market value of any inheritance you receive. Estate taxes vary by jurisdiction and can go from very low to very high depending on local laws.

Understanding what taxes are and why we pay them can get complicated. Taxes were ultimately designed with good intentions. It is designed to support our local communities and our federal government. The taxes we pay help fund a larger effort to strengthen the infrastructure of our world. We should not only focus only on why we pay taxes but also see the bigger picture of what these taxes do and what they fund. It’s the only way to truly understand why we pay them.