Taxes: What They Are and How They Work

Taxes fund the things we need and love. Libraries, roads, hospitals. Without taxes, we wouldn’t have them.

But what are taxes and how do they work?

Understanding taxes in all their various forms can be overwhelming. And then there’s paying them — or worse yet, not paying them.

By understanding what taxation is and how it works, you’ll be empowered to take control of your finances on Tax Day and beyond.

What are taxes?

Simply put, taxes shift resources from private individuals and businesses to the government. They are involuntary fees that the government enforces and collects from businesses and individuals to finance government activities based on what they earn, buy, or own.

In the United States, the Internal Revenue Service (IRS) is set up to collect taxes and enforce tax laws. Generally speaking, the federal government collects income, corporate, and payroll taxes. The state, on the other hand, collects sales taxes, and municipalities or other local governments collect property taxes.

What are the most common types of taxes?

No 1: Income tax

A tax on the money individuals or businesses earn. These taxes are considered marginal, meaning different income brackets are taxed at different rates. They are collected federally but can be collected at the state and local levels, as well.

No 2: Corporate tax

A tax based on the operating earnings of a company after all expenses have been deducted.

No 3: Payroll tax

These are taxes deducted from wages and salaries of employees by their employers on both the federal and state levels. They go towards financing social programs, such as Social Security and Medicare.

No 4: Sales tax

A tax on the money people spend. Sales tax can be collected on state and local levels and makes up a fixed percentage of every sale. It is collected by merchants directly and passed on to the IRS.

No 5: Property tax

Tax on a home, land, or commercial real estate. If you are shopping for real estate, this is an important factor to consider because it can affect the annual cost of ownership even after the property is paid off.

No 6: Capital gains tax

A tax paid on the growth of an investment once it is sold — this doesn’t apply to unsold investments. In today’s digital market with the ease of online trading, it’s important to note that any investment held for less than one year is taxed at a higher rate.

Why do we pay taxes?

Because we have to. The government enacts tax laws — and the IRS enforces them — which makes them a requirement.

The government provides many services — public education, social programming, libraries, national defense, public safety, the building of roads, and more. And all of these services don’t come cheap. To fund them, the government imposes taxes.

When are taxes due?

For federal and state income tax, the answer is usually April 15, also known as tax day. But it can move if the 15th falls on a Friday, weekend, or holiday. The due date has also been moved because of extenuating circumstances — the Covid-19 pandemic, for instance. Federal 2020 tax returns for individuals are now due May 17, 2021. States may or may not follow suit with the extension, so check to make sure you know when they’re due.

And that’s the short answer.

Obviously, the common option is to file your tax return by the due date — which is the case for most individual calendar year filers. But tax preparation can be a doozy, and you may need extra time. In this case, the IRS offers an extension. Although filing for an extension of time to file your tax return is free, it does have a separate due date to keep in mind.

If you miss the extension deadline, the IRS will still accept late tax returns. The later they are filed, the more fees may add up, so you’ll want to send them in ASAP.

Whatever you do, don’t skip out on filing or paying your taxes — it’s just not worth it. The IRS will eventually catch up to you and they may implement some pretty aggressive collection tactics, such as bank account seizure, wage garnishments, or even property liens. Liens can be particularly devastating to your overall creditworthiness and the only way to get rid of them is to pay the balance owed in full.

How do taxes work?

The United States has a progressive tax system. Progressive means the more you make, the more you are taxed. This results in higher earners paying a larger portion of income tax than lower earners.

But there are nuances to consider.

Filing status

For example, you need to consider a taxpayer's filing status. Options include married filing jointly, married filing separately, single, or head of household. The status a taxpayer files under can make a significant difference in how much they are taxed.

Federal tax withholding

In addition, when you start a new job or have a major life change, you will complete a W-4. A W-4 form tells your employer how much they should deduct or withhold from each paycheck to send to the IRS on your behalf. This is known as federal tax withholding. The key with federal tax withholding is to ensure that your allowance is high enough to cover the income tax you will be liable to pay for the year without exceeding it too much and letting the government hold your money interest-free. If you do overpay, you will be issued a refund.

Deductions

You can also itemize your deductions. While there are many different types of deductions, most of them are based on qualifying life events. Others include costs such as self-employment or home office expenses, interest paid toward certain loans, or making charitable contributions. These can be huge money-savers under the right circumstances, but often take more time and require more paperwork. If enough deductions are itemized, a lower tax bracket may be achieved, which is a double win — not only will you pay less tax, but you will pay less tax at a lower rate.

Credits

And finally, there are credits. Similar to deductions, credits can lower your tax bill but are applied differently. Instead of lowering your tax bill indirectly by lowering your overall income, these dollar-for-dollar discounts are taken at the end. Think of credits like a coupon on a purchase after the sale has already been rung up. Many common tax credits are determined by qualifying life events, such as the child tax credit when you have a child, the lifelong learning credit when you pay tuition to attend college, or the saver’s credit for when you contribute to certain retirement accounts.

Bottom line

Taxes are tricky, but understanding them can really pay off — literally. Adhering to the tax guidelines can save you time and money.