Understanding How Your Taxes Work
Taxes refer to funds collected by the government to support its operational activities. Prior to the introduction of income tax, the primary source of revenue for the U.S. government was tariffs, which were taxes imposed on imports.
Direct Taxes
Indirect Taxes
What Are Taxes?
Taxes represent the funds collected by the government to finance its operations. Historically, the US government primarily relied on import taxes called tariffs for revenue before the introduction of income taxes. Today, Americans bear the responsibility of paying various types of taxes, encompassing income taxes, property taxes, sales taxes, sin or excise taxes, capital gains taxes, and estate taxes. There is often debate about the appropriate tax levels; some argue that excessively high taxes can stifle economic growth, while others contend that robust taxation promotes income distribution and serves the common good.
One aspect of taxation that can be challenging for some is that almost everyone contributes to services or policies they may not directly benefit from or support. For instance, your taxes might contribute to public schools that your children do not attend or policies with which you disagree. This, coupled with the financial impact of taxes on our budgets, can make raising taxes a contentious political issue.
Unless you are unemployed or involved in off-the-books employment, you make prepayments toward your tax liability throughout the year through payroll taxes. Payroll taxes are deducted from your paycheck and your employer’s contributions, covering your income taxes, Social Security, and Medicare taxes.
Approximately 30% of your pre-tax earnings is deducted before reaching your bank account, resulting in post-tax earnings that are lower than your negotiated salary with your employer. Understanding the distinction between pre-tax and post-tax dollars is essential, and you can calculate your post-tax income using SmartAsset’s paycheck calculator.
Direct Taxes
A direct tax is defined as a tax paid directly from individuals or businesses to the government entity imposing the tax. Notable examples of direct taxes encompass individual income taxes (remitted to both federal and state governments), corporate taxes (imposed on a company’s profits), and property taxes (levied based on real estate value). The federal income tax faced initial challenges, as the Supreme Court objected to its direct tax nature, as it was not apportioned among states according to population. In 1913, the 16th amendment to the Constitution superseded the Supreme Court’s ruling, officially introducing the direct income tax.
Direct taxes are calculated as a percentage of the taxable entity’s value and are determined by both state and federal legislation.
Indirect Taxes
Indirect taxes are typically applied to transactions involving goods and services such as imports, gasoline, alcoholic beverages, and tobacco. They encompass sales taxes, value-added taxes, sin or excise taxes, and tariffs. These taxes are termed “indirect” because they don’t go directly from the payer to the government. For instance, when you pay a sales tax, you don’t directly remit that money to the government; rather, it’s the merchant selling the goods who submits the sales tax to the government. Indirect taxes are somewhat concealed in nature. Instead of writing a check to the government for the sales tax amount, you pay a higher price for a product like a flat-screen TV to cover the sales tax. These taxes are also referred to as indirect business taxes. In contrast to direct taxes, indirect taxes are uniformly applied to each transaction, irrespective of an individual’s wealth. Critics argue that this approach is unfair because it places a greater tax burden on the income of lower-income individuals compared to wealthier ones.
Tax Benefits and Deductions
Tax expenditures, as defined by law, refer to “revenue losses” resulting from special provisions in the tax code aimed at helping taxpayers reduce their tax burden. These provisions include tax deductions and tax credits. The government can choose to forego tax revenue to offer financial assistance to various groups of taxpayers and to encourage activities that may benefit the economy or communities, such as homebuying or charitable donations.
Tax Deductions: A tax deduction works by reducing your taxable income, ultimately leading to lower taxes owed. The value of a tax deduction becomes more significant as your tax bracket (the percentage of income subject to taxation) increases. For instance, a $500 tax deduction is far more advantageous for someone in the 35% tax bracket than for someone in the 15% tax bracket. This is because 35% of $500 equals $175, which is greater than 15% of $500 ($75).
Tax Credits: Tax credits, on the other hand, directly reduce the amount of money you owe in taxes, rather than lowering your taxable income. For instance, a $500 tax credit means you owe $500 less to the IRS. Tax credits come in two forms: refundable and non-refundable.
Non-Refundable Tax Credits: If your total tax liability (the amount you owe to the government) is, for example, $800, and you receive a $1,000 non-refundable tax credit, your $800 tax liability would be completely offset. However, you wouldn’t receive the remaining $200 ($1,000 – $800).
Refundable Tax Credits: With a $1,000 refundable tax credit, you would receive the full $1,000 from the government, even if your tax liability were only $800.
Understanding these tax incentives can help individuals make informed financial decisions and optimize their tax situations.
Effective Tax Planning Strategies
- Navigating the complexities of taxes can be a daunting task. It's crucial to ensure that you're maximizing every deduction and credit available to you. This is where a knowledgeable financial advisor can prove to be invaluable. Finding the right financial advisor need not be a challenging endeavor. TheSmartAsset team offers a complimentary tool designed to connect you to a qualified financial advisor in your local area. You have the opportunity to interview an advisor at no cost, empowering you to make an informed decision on the one who aligns best with your financial needs. If you're ready to discover an advisor who can guide you toward achieving your financial objectives, take the first step now. Get started on your journey to financial peace of mind.
- The financial advisor may help lower your taxes. One strategy could be to harvest your losses. This means that you will be able to use your investment losses to offset the income that you made from other investments. Another strategy might focus on is Estate Planning, which can protect inherited income for heirs.
Ready to take the next step?
We can connect you with an advisor that will help you find the right tax planning strategies.