Taxes can be a bit complicated. In fact, they’re so complicated and convoluted that there is a massive industry behind it. Whether you need a tax consultant for some in-depth help, or are just using software that helps you file your taxes, every American has become familiar with the scope of the current tax system. Yet, even though Americans understand how complex it is, few actually take the time to educate themselves about the basics. In this article, I’ll be breaking down the fundamentals behind how taxes work in the United States of America. This won’t give you everything you need in every situation, but hopefully it helps and you can contact an expert if you need additional guidance.
Taxes Aren’t Fun
Let’s get this out of the way. Taxes aren’t fun. They’re not entirely simple either. They were not designed to be fun to learn about and understand. Furthermore, they weren’t designed to be easy to understand either – unfortunately. However, it’s still important to take that effort to learn about them. This isn’t the most interesting topic, but its importance can’t be denied. After all, taxes are likely your single largest expense, period.
We Can Agree That They’re Necessary
Despite all this negative talk about taxes, they are necessary for the nation to function. So, do your duty, pay your taxes, but don’t pay more than you’re supposed to. Figure out how to minimize your tax burden – legally. I see no issues with that morally, as you’re still doing your part, and it’s incredibly beneficial for your financial health. Finding ways to lower your taxable income can be a great way to speed yourself up on your journey to financial independence!
Income Tax
The first type of tax we’ll go over is income tax. Simply put, this is the tax taken from your paychecks. Whatever your employer pays you, the government is likely taking a sizable chunk of it. For many people, this is the largest part of their tax bill for most of their life.
We’re Part Of A Progressive Tax System
If you didn’t know, the USA uses a progressive tax system. This means that the higher your income, the greater the percentage of it you pay in taxes. Fortunately, this isn’t quite as bad as it sounds. Let’s take a basic example. This is not a real world case, but simple numbers to make it easy to understand. The first tax bracket is 10% for everything you make. The second tax bracket is 20% of everything you make, and it starts when you make $50,000 annually. So, let’s say you make $80,000. With the progressive tax system, the first $50,000 you make is taxed at 10%. Then, only the amount over $50,000 would be taxed at the higher rate of 20%.
If you’re still confused, you can read more about it at the official IRS website.
Let’s Break It Down
Now that we took a simple example to make things easy, let’s look at the 2022 tax rates.
- 37% for incomes over $539,900 – or $647,850 for married couples filing jointly.
- 35%, for incomes over $215,950 – or $431,900 for married couples filing jointly.
- 32% for incomes over $170,050 – or $340,100 for married couples filing jointly.
- 24% for incomes over $89,075 – or $178,150 for married couples filing jointly.
- 22% for incomes over $41,775 – or $83,550 for married couples filing jointly.
- 12% for incomes over $10,275 – or $20,550 for married couples filing jointly.
- 10% for incomes of $10,275 or less – or $20,550 for married couples filing jointly.
As you can see, income taxes start fairly low, but once you hit a certain threshold it can eat up a huge amount of your income. Additionally, with the current system, it useful to file jointly if you’re married. That isn’t true in every case, but it’s the average case now – so be sure you take advantage of that if you can.
Capital Gains Tax
For those who don’t know, a capital gain is when you sell an asset for more than you bought it, and you gain a profit. A common example of this would be real estate – like selling your property that you’ve lived in for several years.
Capital gains is a bit simpler than income tax. Depending on how much your taxable income is, as of 2022 it will either be 0%, 15%, or 20%. While that sounds a bit hefty, it can actually end up letting you net a much lower tax bill. At most, you’re charged 20% here. When it comes to income tax, you can be charged 37% (not including any state income tax)!
Capital gains taxes come with several special cases and exceptions, which make certain investments worthwhile. In that case, it pays to do your research and contact a professional if you plan on using capital gains as a serious source of income. An example of this use may be for your retirement plan.
Property Tax
Property taxes are usually determined at a far more local level. It can vary wildly over the nation, but the concept is simple. There is a tax-assessed value to your home, and your annual tax on the house will be a percentage of that value. Fortunately, in most states, this isn’t a huge financial strain – and it can even lower your income tax burden.
Sales Tax
Sales tax is another simple concept. Whenever you make a purchase, a percentage of the product’s price is added on as tax that you (as the consumer) have to pay. This varies, but it usually ends up in the range of 7-9% on most products. Again, there are exceptions, but that’s a good rule of thumb. Your local government will also play a big part in how large this tax is.
Reform
As you can see, we actually get taxed in a lot of different ways! In my humble opinion, it is entirely excessive. I would far prefer a scaled back system that did away with a lot of the loopholes we find with the current one. Of course, your opinion may differ. If it does, let me know why and what you would propose instead. I’m always interested in what the Bitter to Richer community has to say!
Conclusion
Hopefully this gave you the fundamental information of how are tax system works at a high level. If you find any parts confusing, or having something to add, let us know in the comments.
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