WHAT ARE TAXES?

According to the IRS, taxes are “required payments of money to governments that are used to provide public goods and services for the benefit of the community as a whole.” Most people and corporations are required to pay taxes in the United States.

Taxes may be imposed by federal, state and local governments. The IRS—or Internal Revenue Service—is a government agency that enforces tax laws and collects federal taxes.

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WHY DO PEOPLE HAVE TO PAY TAXES AND WHAT ARE THEY USED FOR?

Taxes are the main source of income for the U.S. government. Revenue from taxes is used to fund goods and services for the public—like roads, schools and a variety of programs.

Taxes are collected on the Federal, State, and Local levels.

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WHAT'S THE DIFFERENCE BETWEEN TAXES AT THE FEDERAL, STATE, AND LOCAL LEVEL?

Federal tax revenue—plus revenue from court fines, licensing fees and payments to government agencies—may be used to pay for national services and programs, including:

• Social Security

• Health care like Medicare and Medicaid

• National defense

• Economic security programs

• Transportation and emergency services

• Veterans benefits

• Public infrastructure like bridges and roads

State and local governments may tax things like income, sales, fuel and property. State and local taxes may pay for services that include:

• Public schools and higher education

• Health care like Medicaid and the Children’s Health Insurance Program (CHIP)

• Public transportation and infrastructure

• Family financial assistance like the Temporary Assistance for Needy Families program

• Corrections programs

States may also receive grants from the federal government to help pay for things like health care, social services and infrastructure.

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IN WHAT WAYS DOES THE GOVERNMENT COLLECT TAXES?

The U.S. government levies three main types of taxes: on what you

earn (income-based), 

own (wealth-based), and

buy (consumption-based).

Here's what’s included in each type of tax:

Income-based taxes

Income taxes are based on an individual or organization’s earned and unearned income.

Earned taxable income typically comes from salaries, wages, commissions and tips.

Unearned income may come in the form of interest and stock dividends. 

The federal government and most state governments collect corporate and individual income taxes.

Some local governments levy income taxes too. But some states don’t collect income taxes at all.

In these states, other types of taxes might be higher to make up for the lack of income tax revenue.

Income taxes can be broken down into different categories based on the source of the income:

• Personal income taxes: Taxes based on an individual’s income. The federal government uses a progressive tax system that applies higher tax rates to people who make more money. But a number of factors—like filing status, source of income, pre-tax contributions and eligible tax deductions and credits—could affect how much a taxpayer owes.

• Capital gains taxes: Taxes based on the profit from selling certain assets like a house, jewelry or art, and some investments like stocks and bonds. Capital gains taxes can levy a short-term or long-term rate, depending on how long the taxpayer owned the asset.

• Payroll taxes: Taxes typically withheld from a paycheck by an employer. This may include Social Security, Medicare and federal income taxes. 

• Corporate income taxes: Taxes assessed on a corporation’s earned or unearned income.

Wealth-based taxes

Wealth-based taxes are typically applied to the things people or businesses own, including:

• Property taxes: Property taxes are usually imposed on real estate. But some types of tangible personal property like boats, cars and business equipment are subject to taxes too—referred to as Tangible Personal Property taxes.

• Estate taxes: Estate taxes are a tax on the right to transfer property at the time of someone’s death. Estate taxes are applied to the deceased person’s gross estate—or the total amount of assets they transferred to an heir, like money and property.

• Inheritance taxes: Inheritance taxes are similar to but less common than estate taxes. Instead of being imposed on the estate of the deceased person, inheritance taxes are paid by their heirs.

Consumption-based taxes

Consumption-based taxes are typically imposed on things people or businesses buy, such as:

• Sales taxes: Sales tax is applied to nearly every retail purchase. It’s typically a set percentage of the total cost that’s determined at the state and local level.

• Excise taxes: Excise taxes are imposed on certain goods or services like fuel, airline tickets, tobacco, indoor tanning and gambling.

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WHAT ARE TAX RETURNS?

Tax returns are documents that determine how much a taxpayer may owe or be owed in taxes. Most people and businesses are required to file a tax return with the IRS each year. Tax returns include information about the filer’s income, filing status and claimed tax credit and deductions.

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WHAT ARE TAX DEDUCTIONS?

A tax deduction is an amount that can be subtracted—or deducted—from a taxpayer’s total taxable income. Essentially, tax deductions lower the amount of income that’s subject to taxation at the federal, state or local level.

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WHAT ARE TAX CREDITS?

Tax credits can reduce a taxpayer’s taxable income, lower the amount of taxes they owe or increase their refund. And some tax credits may result in a refund even if the individual doesn’t owe any taxes. The Earned Income Tax Credit (EITC), the Child Tax Credit (CTC) and energy tax credits are all examples of tax credits.

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WHAT ARE FICA TAXES?

Federal Insurance Contributions Act (FICA) taxes are a type of payroll tax imposed by the U.S. government that fund Social Security and Medicare programs. FICA taxes are typically deducted from an employee’s paycheck.

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WHAT ARE TAX BRACKETS?

The IRS uses tax brackets to apply different tax rates to certain income ranges.

 

WHAT PERCENTAGE OF MY EARNED INCOME GOES TOWARDS TAXES?

This answer varies depending on multiple factors. Your accountant will help you understand the full picture of what you contribute in taxes and why. However, here are some majority guidelines:
A. If you are self employed as a Sole Proprietor (Schedule C)

1. Self employment taxes - 15.3%

2. Federal Taxes are based on which tax bracket you fall under -  12%, 22%, 24%, 34%

3. State Taxes – Varies by state

4. City Taxes – If applicable (NYC 2%)

B. If you are on a W2 (employee)

1. Federal Taxes - 7.65% 

2. State Taxes - Varies by state 

3. If Applicable – City Taxes (NYC 3%)

​C. If you own an S-Corp / LLC

You pay the same type of taxes as above,

but you get a deduction/write-off on taxes paid
for Social Security/Medicare on the business side;

so, your overall taxable income is lower.

You also get larger write-offs for retirement accounts, health insurance, etc. 

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IF I HAD THE CHOICE SHOULD I PREFER TO GET PAID ON A 1099NEC OR W2?
For a W2, the employer pays one half of your Social Security taxes (6.2%) and Medicare taxes (1.45%) and you pay the other half (that is why you get withholdings on your paychecks). In this format, the government gets the funding for your retirement from both
you and your employer.
For a 1099NEC, You pay DOUBLE Social Security (12.4%) and Medicare (2.9%). You pay a total of 15.3% in self employment taxes. The government gets the funding for your retirement from you only.
Given the choice, choose to be paid on a W2. If that is not an option and you have to get a 1099NEC try to negotiate and ask for a little
more money to cover the additional taxes (6.2%+1.45%=7.65%). As a rule of thumb just remember to add about 8% pay increase for a 1099NEC.

We are not always given this choice, but when we are, this is important to know. 

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ARE THERE ANY INCOME LEVELS THAT DO NOT HAVE TO PAY TAXES?

For a W2, if you earn less than $14,000 in a year, you do not have to pay taxes.

For a 1099NEC, you will always pay taxes, no matter the amount earned.

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AM I TAXED ON MY GROSS OR NET INCOME?

You are taxed on your Net Income.

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WHAT IS THE DIFFERENCE BETWEEN GROSS AND NET INCOME?

Gross Income is the total amount you have earned in a given year before accounting for your expenses (as a business owner) or before payroll deductions are withheld from your wages (as an employee).

Net Income is the amount that you are actually taking home after business expenses or payroll deductions are accounted for.

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ARE THERE ANY STATES THAT DO NOT COLLECT AN INCOME TAX?

There are nine states that do not collect income taxes:

Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. 

However, you will stay pay taxes at the Federal level regardless of where you live. 

Also, opening a business in these states if you do not already reside there is not always the best option. See more on this below in the Business Formations section.