“In this world nothing can be said to be certain, but death and taxes”
“Taxes are the dues that we pay for the privileges of membership in an organized society”
“The hardest thing to understand in the world is the income tax”
“The difference between death and taxes is death doesn’t get worse every time Congress meets”
Taxes. Through the generations they have triggered such a plethora of pithy phrases, all of which show just how much people dislike paying taxes, and often also don’t fully understand them. It’s true, even before the Tax Cuts and Jobs Act of 2017, the SECURE Act of 2019, and the CARES Act of 2020 were signed into law, it was claimed that if the tax code were printed out and stacked, that stack would be taller than 10 bibles tall. Given how much humans argue over religion, can we really be surprised that such a huge document that was constructed piece-meal by years of alternating controlling parties, would be such a mess?
But it being a mess in its entirety doesn’t mean we can’t understand the big picture. Let me walk you through the it, and some of the details more commonly encountered today.
Taxes – The Big Picture
Governments are like corporations, they have areas of responsibility and they produce goods or provide services. Also like any corporation, they need money in order to operate. Unlike a corporation, they don’t sell their services in order to raise these funds. But funds are required, they are the life-blood of the government, and without funds, governments couldn’t meet their obligations to their citizens. These are important obligations, including road construction and maintenance, public safety, education, research, military, and social support systems such as Social Security. Funds for these activities can be raised through one of three methods:
- taking it from others and re-distributing it, which is taxation
- borrowing money in the form of loans, that they are supposed to pay back plus pay interest on
- printing more money
Now all three of these methods have their downsides, but also their positives from the government’s perspective. All three are used simultaneously by most governments, although not in the same proportions.
Taxes are a cheap and easy way for governments to obtain money, and so it’s heavily used to fund the US government and state governments. However, any time anyone has something taken that they view as theirs, they’re going to be unhappy, and therefore taxes tend to be disliked by the masses. Taxation systems have been built over time as well without an over-arching master plan, and tend to be complicated.
When we make a loan to the government, those are called Treasury Bonds – after the US Treasury that’s the originating body for all currency in the United States. The interest rate paid to the person loaning the money is usually low, because it’s considered at low risk of default (default = not being paid back). The duration of these loans varies, from 28 days to 30 years. Different names are attached to these loan durations, they are called Treasury bills, notes, and bonds. Often, an interest payment is given from the borrowing government to the loaner on a periodic basis, and then at the end of the loan window the entire original amount is returned to us. While governments do regularly use this method of raising funds, it’s a higher expense method than simply collecting taxes, and so it’s historically been a smaller part of the US government’s income picture.
Printing more money
Printing more money is a constant in today’s society. This is where inflation comes from, because printing more money devalues the money as a whole. If done rapidly (called hyperinflation) it can sink a government. It’s also a smaller part of the US government’s income picture.
Types of taxation – a multitude of ways of taking money from others
Governments are a system that depend on a re-distribution of wealth. If you are part of a system you can’t opt-out of paying the tolls. As Mahatma Gandhi has stated, “Withholding of payment of taxes is one of the quickest methods of overthrowing a government,” and failure to comply with taxation expectations is usually countered with swift police or military force. The unwillingness of American colonists to tolerate “taxation without representation” was what triggered their uprising against the British, and the American Revolution.
Historically, the act of re-distribution has taken many forms. For example, there was the labor of servants or serfs, as these were people who couldn’t support their overlords via goods or money. There were shares of the harvest given as tithes. There was a requirement to provide food, supplies, and lodging (quartering) to soldiers. And then there are also many avenues of obtaining direct financial support. Infinitely creative rulers may have labeled these as taxes, fees, tolls, duties, tariffs, tithes, charges, or a multitude of other names, but they all had the same effect – transferring wealth from the original holders to a governing body.
Today in the United States, some methods of moving money into the governmental coffers are more common. These are called taxes, fees, tolls, duties and tariffs. Among these you may recognize some methods you have personally encountered:
|Taxation methods||Examples or explanation|
|Consumption tax||Sales taxes or value added taxes, taxes on the transferring of goods between parties|
|Sin taxes or excise duties||Consumption taxes on discouraged products, such as gasoline, tobacco, alcohol|
|Property taxes||Annual taxes based on the value of something you own, such as your home|
|License fees||Annual taxes based on the value of something you own and use in certain venues, such as your car or boat|
|Income tax||Taxes on the business income one earns from working at a job|
|Payroll taxes||This is a mix of unemployment, Social Security disability, Social Security for old age, and Medicare taxes|
|Capital gains tax||Taxes paid on the amount an investment grew between when you bought and when you sold|
|Tariffs||Taxes on imports and exports, the tax rate percentage usually varies based on the items in question|
|Corporate taxes||A general term for all types of taxes levied on businesses|
|Estate, inheritance, death taxes||Taxes on various portions of what’s left behind when someone dies with remaining assets, e.g. leaving behind money and/or valuable things|
State and Federal Income Taxes
When Americans today think about taxes, this is the primary type they think of. In the United States, we have a pay as you go system, where you are supposed to pay taxes as you earn money. Therefore income taxes are one type of money that disappears out of your paycheck before you even get it. However, because our income tax system is complicated, with lots of other things you can owe for or reasons you can owe less, we then all have to file income tax paperwork before ~April 15th of the following year, to reconcile how much we paid vs how much we really should have owed.
Some people like to pay more into the system through the course of the year than they might have needed to, as a sort of forced savings plan – this has two advantages and two disadvantages. Advantages are that you get a “bonus” at tax time to do with as you wish, and that you aren’t suddenly faced with a tax bill you don’t know how to pay. Disadvantages are you’ve given the federal government a 0% interest loan, and you didn’t have use of the money in the mean time.
Some people like to pay less into the system through the course of the year than they owed. This has one advantage and two disadvantages. Advantage – they did have use of the money throughout the year. Disadvantages – they will be faced with a potentially large tax bill come April that they have to have been disciplined enough to save for, and since we’re supposed to pay as we earn, that tax bill may have late fees attached.
It’s very difficult to get the amount taken directly from your paycheck to be exactly the amount you owed, so generally you pick which direction of error you’re more comfortable with; there’s no right answer. The paperwork your employer uses to estimate how much to withhold (eg send directly to the government) is the form called the W4, and you can adjust how much is being taken by filling out a new W4 and filing that with your employer. And there’s a tool you can use on the IRS website, to figure out how much should go into that form.
Most states also charge income taxes, which is why in those 41 states you also have to file income tax paperwork with your state. As independent entities, state income tax rules don’t have to look much like federal income taxes, let alone those of another state. You may have to file income taxes in more than one state if you earned income or lived in more than one state during that year.
How much do we pay? Like Sisyphus, any year we have income we are pushing rocks up a hill, where the steepness of the hill is your tax rate. If you imagine the base of a hillside where there’s a straight line slope, that’s a flat tax system. Then imagine a where the slope gets steeper as you get higher up the hill. That’s what we’ve got here in the United States. It’s referred to as a progressive tax system. That is, the more you earn, the more you pay in taxes, not just as a dollar amount, but as a percentage of what you’ve earned. The 2020 tax rates range from 10-37%.
A common misconception is confusing your marginal tax bracket with your average tax rate. Let’s illustrate that with an example.
We have a married filing jointly couple who earned $100,000 at their jobs. They will take the standard deduction of $24,800, leaving the remaining $75,200 subject to federal income taxes. The next $19,750 dollars are subject to a 10% tax rate, the remaining $55,450 are subject to a 12% tax rate. Their average or effective tax rate is the weighted average, and that’s less than their marginal tax bracket:
0% x $24,800 + 10% x $19,750 + 12% x $55,450 $0 + $1,975 + $6,654
———————————————————————— x 100 = —————————– x 100 = 8.6%
0% x $24,800 + 10% x $19,750 + 12% x $55,450 $100,000x 100
$0+$1,975+$6,654 $100,000x 100
For our example couple, their marginal tax rate is 12%, however their effective tax rate is 8.6%. The marginal tax bracket is a labeling of the steepest part of the slope you pushed the rock up, but the effective tax rate is the average of how steep the hill was for all of your rock pushing.
Interest and Ordinary Dividends
To own stocks is to have partial ownership of a company. This can be done through individual stocks where you own imaginary company “ABC Company” directly. Or it can be done through mutual funds or ETFs, where you own a big bucket of stocks, of which ABC Company may be one. Many companies pay dividends, which is the company paying some of the profits to the company owners directly. Often these dividends are classified as “ordinary dividends”. If ABC Company pays ordinary dividends, then this income to you as an owner of ABC Company is taxable like your regular paycheck, e.g. as ordinary income.
Similarly, if your bank or credit union pays you interest for holding your money with them, such as in a savings account or in a Certificate of Deposit (CD), that money is also taxable like your regular paycheck, as ordinary income.
The government is a fan of the buy and hold strategy of investing, and rewards this type of investing with preferential tax treatment – in plain English, that means lower taxes if you do what they encourage.
Let’s go back to our imaginary ABC Company.
If you’ve held a mutual fund that has low turn-over, e.g. the mutual fund bought ABC Company years ago and hasn’t sold it, then when they distribute profits to the owners via dividends, those dividends will be taxed at rates lower than ordinary income is taxed at. Instead of being taxed at 10-37%, they are taxed at 0-20%. These are called “qualified dividends”.
Capital gains are profits you make from buying and selling stock shares or mutual funds. If you bought ABC Company, but you sold it again in a year or less, that’s discouraged behavior; and you’ll pay ordinary income tax rates (10-37%) on these “short term” capital gains. Holding your investment longer than a year is encouraged, and so in that scenario your profits are taxed at that better 0-20% rate. So it’s a far better deal from a tax perspective to hold your investments for over a year.
One additional catch – if you have a high income from earned income plus investments, you may be subject to an additional 3.8% tax on a portion of that income, known as the Net Investment Income Tax.
Why to Invest in Tax Advantaged Accounts
As we’ve mentioned, the federal government’s income tax system is complicated. Some of this complexity is actually for our benefit, when the government wants us to have financial behaviors that benefit the country as a whole, or discourages other behaviors by taxing income from those behaviors at a higher rate. Examples of these encouragements include earning a paycheck (Earned Income Tax Credit), encouraging pursuing higher education (American Opportunity Tax Credit and Lifelong Learning Credit), and encouraging low to moderate income households to save for their retirement (Savers Credit).
There are three primary ways the government also encourages individuals to proactively save for their own future expenses.
First, the government wants to encourage all individuals to save for their retirement. To do so, the tax code provides for a number of retirement vehicles, each with tax advantages. If you have earned income, you can invest in an Individual Retirement Arrangement (IRA), which is a retirement account you set up with a financial institution, separate from your employer. Some employers have one or more types of retirement accounts (such as a 401k, 403b, or 457b) that they coordinate for their employees, and these may include a match – free money the employer provides as part of your pay, although they may require you to make retirement account contributions with them in order to receive it. Either way, this money needs to stay invested until you meet the governmental criteria for retirement, which is typically getting to age 59 ½, before you can withdraw these funds without penalties. Whether you’re investing for retirement individually or through your employer, these retirement accounts have one of two types of preferential tax treatment.
- Remember, earned income is taxed when you earn it (income tax), you are taxed when you earn money on it (dividends), and you are taxed when you take money out of investments (capital gains).
- Traditional retirement accounts have their contributions made pre-tax, so you don’t pay income tax on the money that went into it. You also aren’t taxed as it grows, although the dividends have to stay in the retirement account. The only time you’re taxed is when you take the money out. At that time, you’re taxed at ordinary income tax rates (currently 10-37%), just like the original income would have been. Typically this type of investment is chosen when:
- Your employer retirement account options don’t include a Roth option.
- You believe you are in a higher tax bracket now when you are contributing than you think you might be at retirement when you’re taking the money back out.
- Roth retirement accounts have their contributions made post-tax. You do pay income tax on the money that went into it. But you aren’t taxed when that investment grows, when money is earned by your investment. And you also aren’t taxed when you take the money out. Typically this type of investment is chosen when:
- You believe you are in a lower tax bracket now than you will be at when it’s time to take the money out, either through lower earnings or through rising future tax rates.
Secondly, the government realizes that rising medical costs are problematic. One method of governmental encouragement for individuals to save for future medical costs is a Health Savings Account (HSA). Access to this does require utilization of a High Deductible Healthcare Plan, which isn’t always available or the right answer for everyone. However, if you do utilize an HSA, they are like a combination of the best of traditional and Roth retirement accounts:
- Contributions made pre-tax, so you don’t pay income tax on the money that went into it.
- You also aren’t taxed when your investment grows, and dividends are paid.
- And you aren’t taxed when you take the money out, as long as you’re using them for appropriate medical expenses.
And third, there are 529 plans, for saving for college. Dollars you earned and invested in a 529 plan were taxed when they were earned, but their growth and their withdrawal are not taxed, as long as you’re using them for appropriate higher education costs. This taxation type is like the Roth version of the retirement account.
No matter what you’re saving for, if you have access to a tax advantaged account for it, the government wants to encourage you to save. And saving in a tax-advantaged way will give you more money at the end of your savings journey than you would have had if you hadn’t taken the tax advantages.
Payroll taxes are on your earned income (from your job), that are specifically set aside as a benefit to former workers who have retired, had medical issues force them into a disability status, or the dependents of such workers. That is, these funds are for Social Security (officially Federal old-age, survivor, and disability insurance benefits), Medicare part A (the hospital insurance portion). They also help fund unemployment programs. There are four parts to these payroll taxes.
- A tax on the earned income of the employee, 6.2% for Social Security and 1.45% for Medicare. These are automatically taken from your paycheck, and unless you have special situations like self-employment, tips, or high income across multiple employers, doesn’t require additional reconciliation on your tax return that’s due each April. The Social Security contribution does cap out after you’ve earned enough; the 2020 income threshold is $137,700, it’s called the “Social Security wage base”. The Medicare contribution does not have a wage cap.
- A tax on the employer, 6.2% for Social Security and 1.45% for Medicare. This doesn’t cap out for either the Social Security or Medicare contribution. It’s taken directly from your employer, and doesn’t show up on your pay stubs, your income taxes, or any other employee documents.
- A tax on the employer, 6% up to a wage cap of $7,000. This helps fund the unemployment system.
- An additional tax on earned income of the employee, 0.9% for Medicare above a high income threshold – above $250,000 for married filing jointly household returns, and that income threshold doesn’t increase with inflation.
Updates to Our Tax System
Our federal income tax system is typically modified by every legislature session, and overhauled every ~30 years. The Tax Cuts and Jobs Act of 2017 was one such overhaul, and the new COVID-19 stimulus bill signed by President Trump on December 27, 2020 was the most recent modification.
Taxes are a large and complicated part of the American landscape. With this introduction, you now have the big picture view of how they may impact your life.
About the Author:
Tina Wood-Wentz is a numbers geek and educator, has worked in tax preparation and as a tax instructor, and is the founder and financial educator behind Wood Financial Services LLC. You can find many more educational articles about taxes, corporate benefits, investing, and personal finance in general, on her blog.