Spending on Taxes

How to pay taxes in America and tips for reducing your income tax.

This is a chapter preview. To read the full chapter, click here. 

TL;DR

1. In America, it’s your responsibility as an individual taxpayer to calculate the money you owe for personal income taxes. Hence, knowing how much you should expect to pay and withhold from your income throughout the year is important.
2. Americans file taxes using Form 1040, while Forms W-2 and 1099 show a record of your income.
3. Tax deductions reduce the amount of your income subject to taxes, while tax credits can reduce the amount of tax you owe or increase your tax refund.
4. The IRS offers resources to file your taxes, including free tax return preparation for those who make $58,000 or less, have disabilities, or are limited in their English-speaking abilities. 

Taxes are an unavoidable and necessary part of a functioning society. However, taxes in America are exceedingly complex. Every year, Americans file their income taxes to determine the amount of money they owe the government. But, as an American, taxes are actually paid year-round on what you earn, what you buy, and what you own. Understanding how taxes influence the amount of money you keep, save, and spend is a fundamental component of your financial well-being.  

 

 

 

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Types of Taxes

Taxes on What you Earn

Your individual income tax (or personal income tax) is applied to money earned from work and investments. The federal government and many state governments use money from your individual income tax to fund public services, pay government obligations, and provide goods for citizens.

The federal income tax rate is progressive, meaning your tax rates increase as your income does. Higher earners, therefore, spend a higher percentage of their income on taxes than lower earners. The current income tax rates range from 10 percent to 37 percent, depending on an individual's annual income. The ranges these rates apply to are called tax brackets, and all income within each bracket is taxed at the corresponding rate. The 2022 tax bracket rates are shown below:

Federal tax brackets are subject to change. For current rates, refer to the IRS website.

Consider each bracket an “up to” amount. Every dollar earned up to that amount is taxed at the corresponding rate. Only money earned above each rate is taxed at the rate above. For example, if you earned $40,000 in 2022, $10,275 would be taxed at 10%, and the difference, $29,725, would be taxed at 12%. In total, the amount of taxes owed to the federal government would be $4,594.50. The math for this number is shown below:

Because only the money above a given tax bracket is taxed at a higher percentage, it is always worth accepting a pay increase. Additional income may push you into a higher tax bracket, but only the top strata of your earnings will be taxed at a higher rate. 

Money earned from investments, another source of income, is taxed at standard federal tax rates unless you hold the investment for a year or more. If you do, the government rewards this extended holding period by charging a lower tax rate called the long-term capital gains rate. The long-term capital gains rate is a flat 10% on income from investments sold after a holding period of at least one tear. As an example, if you earned $10,000 in 2022 from an investment held for six months, your new total annual income of $50,000 would be taxed at the short-term capital gains rate, or progressive rate, as shown below:

However, if you earned $10,000 from the same investment after holding it for over a year, the income from this investment would be taxed at the flat capital gains rate of 10%. In total, you would pay $5,594.50 in annual federal taxes:

In this example, holding the investment for a year saved $809.50 in federal taxes

In addition to your federal income tax, many states charge an income tax as well. Whether or not you are subject to state income taxes and how much you owe varies by residency. As of writing, 43 states charge state income taxes, and seven do not. Those that do charge either a flat rate or a graduated-rate comparable to the federal tax bracket system. You can find an overview of the tax system in every state on the Tax Foundation website, the nation’s leading independent tax policy nonprofit. A visual representation of the tax rates for each state is shown below:

Although seven states do not charge an income tax, that doesn’t necessarily result in a cheaper cost of living. This is because states often make up the lost revenue with other taxes or reduced government services. Additionally, other factors determine a state’s affordability, including healthcare availability, local cost of living expenses, and job market health. 

Taxes on what you buy

Taxes on what you buy include sales and excise taxes. 

A sales tax is a consumption tax imposed by the government on the sale of goods and services.

A conventional sales tax is levied at the point of sale, collected by the retailer, and passed on to the government. Like an income tax, a sales tax supports local and state governments. All but five U.S. states collect sales taxes: Alaska, Delaware, Montana, New Hampshire, and Oregon.

An excise tax is an additional sales tax on specific goods or services. Examples of excise taxes include those on cigarettes, alcohol, and betting. The government levies excise taxes on products and services to dissuade citizens from indulging in them by making them more expensive. For this reason, excise taxes are often labeled “sin taxes” because of the products they are associated with.  

Taxes on what you own

Taxes on what you own include property taxes, estate taxes, and wealth taxes.

Property taxes are primarily levied on immovable property like land and buildings and are a source of revenue for state and local governments.

Property taxes in the U.S. account for over 30 percent of total state and local tax collections and over 70 percent of total local tax collections. Local governments rely on property tax revenue to fund public services like schools, roads, fire departments, and emergency medical services.

Property taxes, like sales taxes, vary by state

Estate and inheritance taxes are paid on the transfer of property upon death to heirs. Typically, both the estate and heirs pay taxes on this transfer. 

Lastly, a wealth tax is an ownership tax charged to those with a net worth over a certain threshold. The United States does not charge a wealth tax now, but politicians interested in sourcing additional tax revenue from society’s most wealthy could implement it.

How to Pay Income Taxes       

In America, the burden of correctly calculating and paying for one’s income taxes falls on the individual taxpayer. Therefore, it’s imperative to understand how and when to pay them.  

Personal income taxes are paid throughout the year to the federal and state governments via a withholding tax. A withholding tax is the money an employer deducts from their employees’ gross wages and pays directly to the government. Tax withholding is a way for the U.S. government to maintain its “pay-as-you-earn” income tax system — taxing at the source of income rather than trying to collect income taxes after wages are earned. Employers are required to pay this tax on your behalf, however, you can determine the amount withheld. Experts recommend withholding at least 90% of the annual taxes you owe from your net pay. Doing so ensures you pay most of the taxes you owe while not overspending throughout the year. If you do overspend, the government will refund you the difference after you file your taxes. However, money spent above your necessary tax bill could have grown during the interim in a savings or investment account. 

Some workers, like independent contractors, don’t have their income withheld during the year. For them, they need to estimate their annual tax liability and pay this amount every quarter. 

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Although you pay income taxes throughout the year, you must reconcile, file, and pay them in full by the conclusion of the tax season the following year, typically in April. For reference, taxes owed for the 2021 calendar year had to be filed and paid by April 18, 2022. 

You pay federal taxes to the Internal Revenue Service (IRS), the U.S. government agency responsible for collecting taxes and enforcing tax laws. In contrast, you pay state taxes, if required, to your state’s treasury department. Calculating the taxes you owe in a given year is done by filing your tax return. 

To file your federal tax return, start by collecting the paperwork provided by your employer showing the amount of money they withheld on your behalf for the year. If you are salaried, your employer will provide a W-2 via mail or your company’s HR portal at the end of the calendar year. If you earned money as a contracted worker or through investments, a 1099 form will show the amount earned. Like a W-2, 1099s must be provided by the business you made money from. 

Next, choose your filing status, i.e., whether you will be filing as an individual or a married couple, and determine how you want to file your taxes with the IRS by completing Form 1040. You can file Form 1040 via mail or online. 

You can choose to file your taxes yourself or use the assistance of a tax professional. The IRS provides several resources to help you complete and submit this filing, including links to qualified tax professionals who can file the form on your behalf for a fee. The IRS also offers free tax return preparation for eligible taxpayers, such as those who make $58,000 or less, have disabilities, or are limited in their English-speaking abilities. 

Lastly, determine whether you will take the standard deduction or itemize your return. The purpose of both is to reduce your tax burden. The standard deduction evaluates your filing status and several additional factors to provide an amount of money that you can deduct from your annual tax liability. For example, if you made $50,000 in one year and your standard deduction was $10,000, you would owe taxes on $40,000 of income ($50,000 - the $10,000 deduction.) Itemizing your return allows you to calculate your tax deduction by specifying the expenses that reduce your tax liability. Ordinary itemized expenses include medical bills, mortgage payments, and gifts to charity. Choosing which method to use involves identifying what saves you more money. Note that additional restrictions may determine which of these options you can take. Review the IRS website for any questions on the filing process and consider consulting with a tax professional.   

Reducing Income Tax Liability