The United States has one of the most complex tax systems in the world. This guide to U.S. taxes will familiarize you with the types of taxes Americans pay. Raising revenue for the federal government is the primary purpose of our tax system. It comprises 40 percent of all money the U.S. Treasury takes in. Roughly half of all tax revenue is in the form of income tax. Yet, there are many different types of taxes that Americans pay. The better you can understand taxes, the more you can reduce taxes.
We pay income tax at the federal, most state, and local levels in the United States. Individuals, corporations, estates, and trusts all pay income tax, albeit at different rates.
The first step in calculating your income taxes is to add your income sources together. After you have calculated your gross income, you then subtract your deductions. The result is your taxable income.
Additionally, tax credits can reduce your taxable income. Now you are ready to determine your tax liability
Federal Income Tax
We have a graduated or progressive federal tax system. As of 2020, there are 7 different federal tax brackets. They start at 10% and increase to 37%. Most Americans file “single” or “married filing jointly.” But you can also file “married filing separately” or as “head of household.” Every filing status has different tax brackets, but the percentages remain consistent.
Knowing how close you are to the next bracket can be very helpful in reducing taxes. There are many tax reduction strategies that can push your income down into a lower bracket. The more you know, the more you can save.
State Income Tax
Besides federal taxes, most states also impose an income tax on their residents. In California, state taxes start at 1% and increase to 13.3% on income over $1 million. Most Americans file a federal and state income tax return.
It is important to be mindful of the total marginal tax that you pay. If your income is over $1 million and you are a California resident, you will pay 37% federal and 13.3% state tax. This results in a combined marginal tax bracket of 50.3%. So for every dollar of taxable income over $1 million, half of it goes to taxes for California residents.
There are 9 states that do not assess income tax on individuals. They can be popular destinations for retirees looking to maximize retirement income. The 9 states are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
Capital Gains Tax
A capital gain is a profit from the sale of property or an investment. Selling an asset that has increased in value triggers a capital gain. This increases your tax liability in the year of sale.
Short-term capital gains are taxed at ordinary income tax rates. Selling an asset held for a period of less than one year constitutes a short-term capital gain.
Long-term capital gain rates are taxed at 0%, 15%, or 20%, depending on your federal marginal tax bracket. Selling an asset held for a period of more than one year results in a long-term capital gain.
Selling an asset that had decreased in value from its cost results in a capital loss. While you don’t want this to be a frequent occurrence, there is a tax benefit.
You can use losses to offset gains in the current year. The rules dictate that short-term capital gains and losses must be reconciled first. Then long-term capital gains and losses.
The result is your net short-term and long-term gain/loss. As an example, a $10,000 short-term gain and $4,000 long-term loss will result in a $6,000 net short-term capital gain.
But what if you don’t have losses in the current year? Losses are then carried forward and used in future tax years. One exception is that you can take $3,000 of your loss carryforward as a deduction every year. This is until the loss carryforward loss balance is used up.
Net Investment Income Tax
The Net Investment Income Tax is an extra tax on investment income. It is a 3.8% tax that applies to dividends, interest, and capital gains. This tax applies to single taxpayers with modified adjusted gross income above $200,000 for single taxpayers. It also applies to married filing jointly taxpayers once MAGI reaches $250,000. The tax excludes any gain from the sale of a primary home.
Social Security and Medicare Taxes
Payroll taxes are taxes paid on wages and salaries on employers and employees. Most employees are familiar with payroll taxes by seeing withholdings on their paychecks.
The major payroll taxes in the U.S. are 12.4% percent to fund Social Security and 2.9% to fund Medicare for a combined rate of 15.3%. Social Security taxes are subject to a maximum wage limit of $137,700 in 2020. There is no wage limit for Medicare taxes.
Employers pay half of these payroll taxes (7.65%) while the employee pays the other half. So self-employed individuals are responsible for paying the full 15.3% tax on their wages.
Employers pay unemployment taxes assessed by federal and state governments. The total amount of wages paid by the employer (up to a cap) are subject to unemployment taxes. Some states like California also impose a tax on unemployment and disability insurance.
Estimated Tax Payments
Employees pay their income tax liability through withholding from their paychecks. Self-employed individuals and retirees do not receive all their income from wages. But the IRS is not willing to wait until they file their taxes to collect their tax revenue. They want you to pay as you go along.
Estimated tax payments are required from taxpayers based on their income. You are subject to estimated tax payments if you’ll owe at least $1,000 in federal income taxes in the current year.
Generally, an underpayment penalty can be avoided if you use the safe harbor rule for payments. The IRS will not charge an underpayment penalty if you pay at least:
- 90% of the tax you owe for the current year, or
- 100% of the tax you owed for the previous tax year.
There are two exceptions to making estimated payments. If you owe less than $1,000 of tax in the current year or had zero tax liability last year.
Real property gets taxed at its fair market value on a specific date each year. Examples of real property are land, buildings, and other permanent improvements. This applies to your primary home as well as rental properties.
Types of Property Taxed
Real estate by far is the biggest source of property tax revenue for the IRS. But other property such as automobiles and boat registration fees are also a subset of this tax.
Tangible personal property is things like business equipment, machinery, inventory, furniture, and automobiles. This is property that can be moved or touched. Many local and state jurisdictions collect tax on tangible personal property.
States with Lowest Property Tax
Alabama, West Virginia, and Arkansas have some of the lowest property taxes of all states. There are also 13 states with no property tax for seniors over the age of 65. This provides an incentive for retirees who are seeking to maximize their retirement income. The 13 states are:
- South Dakota
- South Carolina
- South Carolina
- New York
- New Hampshire
Sales and Excise Taxes
The U.S. is one of a few industrialized countries that still impose retail sales taxes. While state income tax is a primary concern for U.S. residents, a state’s sales tax adds to your overall tax liability. All states assess sales taxes except for Alaska, Delaware, Montana, New Hampshire, and Oregon.
Also, many cities, counties, and transit authorities impose extra local sales or use tax on goods and services. State sales tax can vary from less than 1% to over 10%.
Excise taxes are for businesses, separate from other taxes such as income tax. But in some cases, consumers may directly see the added tax.
Many excise taxes are paid by merchants who then pass the tax on to consumers through higher prices. A federal excise tax is collected from goods and services such as motor fuel sales and airline tickets.
Governments levy excise taxes on goods with a high social cost. Some examples are cigarettes and alcohol to discourage their consumption. These products increase health risks leading to higher national healthcare costs.
Tariffs have been a popular topic in the news in recent years. The United States imposes customs duties or tariffs on the import of goods. The tax rate imposed depends on the country of origin.
Like excise taxes, the importer handles payment of the tariff. So even though this is not a direct tax on the consumer, the cost is inherent in the price of goods.
When the last member of a household passes away, the estate is subject to estate taxes. So the estate is subject to taxation before any beneficiaries receive assets.
The good news is that today the state tax exemption is higher than it has ever been. Each person has an estate tax exemption of $11.58 million in the year 2020.
So a married couple’s estate valued at under $23 million would be exempt from paying estate tax. The estate tax exemption has increased since the year 2000 when it was $1 million.
There are limitations on giving away assets to someone. The limitations apply to the giver, not the recipient. One of the primary purposes of gift taxes is to ensure that taxpayers don’t give assets away before death. This would result in much lower estate tax revenue for the IRS.
To avoid this, the gift and estate tax exemption amounts are tied together during your lifetime. As an example, let’s say you made a gift for $1.58 million 20 years ago. If you were to die in the year 2020, your estate tax exemption would be reduced from $11.58 million to $10 million.
Annual Gift Tax Exclusion
Every year you can give up to $15,000 to someone and not have to deal with the IRS about it. This exclusion means that you do not have to claim the gift when filing. A married couple can gift $30,000 to a beneficiary of their choosing without incurring any gift tax. So a married couple with 3 children could gift a total amount of $90,000 every year.
Taxes are the number one revenue source for the federal government. They are also at the forefront of most of our financial decisions. The U.S. tax code is quite complex and there are various ways that we pay tax.
Having a better understanding of tax law provides more planning opportunities. There are many tax reduction strategies available whether you are still working or in retirement. Utilizing these strategies is critical to ensure you make the best financial decisions.
It is a good idea to work closely with your financial planner or tax professional so you can make the best financial decisions.