What Are Taxes?

How Taxes Work

Taxes work by allowing government entities to collect payments from individuals and businesses to generate revenue. Money raised from taxes then is used to fund government operations and public service programs.

The government that imposes each tax has a particular set of laws governing the amount and collection of that tax. Those laws and the type of tax determine how different tax systems work. 

That said, some key concepts generally apply across tax systems, such as:

• Tax base: The items or activities subject to a tax
• Tax rate: The percentage of a taxpayer’s tax base that is used to calculate the taxpayer’s tax liability
• Tax return: A form or series of forms filed by taxpayers with the government imposing the tax on which a taxpayer’s tax liability is calculated and tax payments are reconciled.

For example, the tax base for federal income tax in the U.S. is a taxpayer’s taxable income. Marginal tax rates are set every year by the IRS. The tax bracket you land in determines how much tax you pay. Someone who files single and earns more than $89,075 but $170,050 or less, for instance, would be in the 24% tax bracket for the 2022 tax year.

Types of Taxes

There are different types of taxes a government can impose. Here are some of the key types of taxes you might expect to pay during your lifetime.

Income Tax

Income tax is a tax on income. The first American income tax was established in 1861 to raise money for the Civil War. That tax was later repealed, but eventually, the federal income tax was formalized through a constitutional amendment in 1913.

The IRS collects federal income tax for the government. States can also assess an income tax, although there are seven states that don't:

• Alaska
• Florida
• Nevada
• South Dakota
• Tennessee
• Texas
• Wyoming

New Hampshire assesses a flat income tax but only for interest and dividend income. Washington state only taxes the capital gains income of high-income earners.

The amount of income tax you pay can depend on your income and filing status. There are five filing statuses recognized by the IRS:

• Single
• Married filing jointly
• Married filing separately
• Head of household
• Qualifying widow(er) with a dependent child

If you're unsure which one you are, you can use the IRS What's My Filing Status tool to select the right option.

Payroll Tax

Payroll taxes are taxes assessed on the wages and salaries of employees. Employers collect payroll taxes, then forward them to the appropriate state and federal tax collection agencies. 

Two of the most notable payroll taxes are Medicare and Social Security taxes. These taxes are used to fund each of those programs, respectively. The withholding rate for Medicare tax was 1.45% for the employer and 1.45% for the employee, or 2.9% total. The withholding rate for Social Security tax was 6.2% for the employer and 6.2% for the employee, or 12.4% total.

Corporate Taxes

Corporations must pay taxes out of their profits to the federal government. Corporate entities have an opportunity to offset the amount of tax owed by claiming deductions for eligible expenses. For example, if a restaurant invests money in purchasing a food truck to help expand its clientele, it generally would be able to deduct the cost of the truck and the materials required to stock it.

The top corporate tax rate is 21%. Prior to the passage of the Tax Cuts and Jobs Act, the top corporate tax rate was 35%.

Sales Tax

Sales tax is a tax collected when you buy something online or at a store. For example, if you pick up groceries on the way home from work, the grocery store adds sales tax to the bill. That sales tax is forwarded to the appropriate state or local tax agency.

Each state sets its own sales tax rate. In tax year 2022, the state with the highest sales tax rate was California, at 7.5%. Five states—Alaska, Delaware, Montana, New Hampshire, and Oregon—don't assess a state sales tax. Alaska does allow for the collection of sales tax at the local level.

Property Tax

Property taxes apply to property, including homes, land, and vehicles. If you own a home, property tax payments may be escrowed into your mortgage payment. Your home's value and the tax rate that's used by your local or state tax assessor determine how much you owe. Some of the highest effective property tax rates are in New Jersey, Illinois, and Texas.

Tariffs

A tariff is a tax that one country imposes on another for imported goods. For example, if one nation exports 20 tons of bananas to a neighboring country, the country receiving the shipment might charge a tariff for the import.

Estate Taxes

Estate taxes are applied to estates that exceed the exclusion limit established by the IRS. For 2022, the exclusion limit was $12.06 million, which doubles for spouses. For 2023, the federal exclusion limit is $12.92 million.

The estate tax is assessed based on the difference between the value of your estate and the exclusion limit. States can apply their own estate taxes, although the exclusion limits are typically lower.

Capital Gains Taxes

Capital gains tax applies when you sell an asset for more than what you paid for it. For example, if you buy 100 shares of stock at $10 each, then later sell them for $30 each, the $20 per share difference in price would be a capital gain.

The short-term capital gains tax rate applies to investments held for less than one year. The long-term capital gains tax rate applies to investments held for longer than one year. Short-term gains are taxed at ordinary income tax rates, while the long-term capital gains tax rate is 0%, 15%, or 20%.

How To File Taxes

Knowing how to file taxes is important because failing to file on time can result in penalties and fees. How you go about filing taxes can depend on whether you're paying them at the federal, state, or local level.

Federal Taxes

To file federal taxes, you'll need to collect certain documents relating to your tax information and choose how you'd like to file. Some of the documents you might need in order to file federal taxes include:

• W-2s from your employers
• Form 1099s if you earn income as an independent contractor or freelancer
• Form 1098, if you plan to deduct interest paid toward your home loan
• Form 1098-E, if you plan to deduct interest paid toward student loans
• Receipts for deductible business expenses or medical expenses
• A brokerage statement showing your capital gains and losses from investments for the year
• A record of contributions made to a retirement account

Once you've organized your documents, the next step is deciding how to file. You can file federal income taxes using a paper form, but the IRS generally recommends e-filing so you can get your refund faster if you're owed one.

If you're filing online using a tax software program, the program may guide you through the steps necessary to complete your return. That includes choosing the appropriate filing status and looking for every eligible deduction or tax credit.

State and Local Taxes

The process for filing state income tax is similar to filing federal taxes. In fact, if you're using an online tax software program, you may be prompted to transfer your information over from your federal return once it's complete. You might have to answer a few additional questions to finalize your state return—but otherwise, it's fairly easy.

If you're paying taxes to local authorities, such as property tax, you might be able to do that online, over the phone, by mail, or in person at your local tax office. Sales tax is collected at the time of purchase, so you don't need to take extra steps to pay that.

Frequently Asked Questions (FAQs)