What are Taxes?

Paying taxes is like snack duty for a youth soccer team...

Part of being on a soccer team is snack duty. When it’s your week, you have to bring snack for everyone to enjoy — for example, orange slices. Everyone is relying on you to bring the oranges and they benefit the entire team. If you forget (or neglect) to bring a snack, you might not be allowed to play—and you might even have to double up on future snack duties to make up for it. Similarly, when you pay your taxes, your contribution is for the benefit of the entire society. Your taxes help pay for social services and infrastructure that’s available to everybody, like roads, other public works, and education.

Most people pay several different types of taxes. Let’s talk about some of the most common types.

Income taxes are what we pay as a percentage of our incomes. The amount of money that we make determines what percentage of our income we have to pay.

The Internal Revenue Service (IRS) collects income taxes on a pay-as-you-earn basis, meaning you have to pay taxes on your income throughout the year. As a result, your employer typically withholds money from your paycheck to pay the government.

After the year ends, we have to file a tax return with the IRS. On this tax return, we tell the government how much we earned throughout the year and how much we’ve already paid in taxes. In the end, we either get a refund from the government for overpaying our taxes (this means we get some money back), or we receive a tax bill and we have to pay what we still owe.

Here are the income tax rates for an individual taxpayer in 2020 (taxes that are due spring 2021):

Did you know? Income taxes represent the largest source of revenue for the federal government. About half of federal tax revenue comes from individual income taxes.

Most states also have a state income tax, but as of 2012, seven states don't: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. If you live in one of these states, you’ll still have to pay federal income taxes.

Corporate taxes are like income taxes, but for businesses. Companies pay a percentage of their profit for the year in taxes.

Unlike individuals who pay a tax rate based on their income level, most corporations are subject to a flat income tax of 21%, as of 2021. Corporate income taxes make up just a small share of the federal government’s annual revenue.

If you own a home or any other type of property, you likely have to pay property taxes. State and local governments levy property taxes to pay for government expenditures. School districts also sometimes levy property taxes to help fund educational and infrastructure expenses in the school district.

The amount you’ll pay in property taxes will vary widely depending on where you live. You usually pay property taxes as a percentage of the value of your home. Both the cost of housing and the property tax rate in your area will impact your property tax bill.

You’ll pay capital gains taxes when you sell an asset and the sale results in a profit for you.

Capital gains taxes apply to other things beyond physical assets–the same thing happens when selling stock: if you sell it for more than its purchase price, you’ll owe capital gains tax.

The percentage you pay in capital gains depends on your individual income, not on the value of the asset. As of 2021, the rate you’ll pay in capital gains taxes will either be 0, 15, or 20 percent, depending on your income. In some cases, usually when the asset is held for less than a year, you'll be taxed at your income tax rate (rather than the capital gains tax rate).

For an individual, these rates are as follows for 2020 (taxes due spring 2021) and 2021 (taxes due spring 2022):

When you buy goods and services, you’ll often pay sales taxes on your purchase. Sales tax applies at the time you make the purchase. The seller collects the taxes and then sends those dollars to the appropriate government body. The amount you pay in sales tax is a percentage of your total purchase amount.

The federal government does not collect sales taxes. Instead, state and local governments collect these taxes. In some places, you’ll pay sales taxes to both levels of government, while individuals in other locations will pay sales taxes to just one level of government.

In addition to withholding income taxes from your paycheck, your employer also withholds Federal Insurance Contributions Act (FICA) taxes. FICA taxes are payroll taxes that pay for Social Security and Medicare, both of which are vital government programs to help senior citizens. Payroll taxes make up more than 25% of the federal government’s annual revenue.

As of 2021, the FICA tax is 7.65% of income. Your employer also pays 7.65% of your income in FICA taxes. Self-employed individuals pay both the employee and employer portion of the FICA tax — This is often referred to as self-employment taxes.

Taxes help pay for things we all have access to, such as roadways, law enforcement, and public education. Taxes also help to pay for programs to help our nation’s most vulnerable. These programs include the Social Security program, which provides income to older individuals, and Medicaid, which provides health insurance coverage to low-income families.

The longer you wait to file or pay your taxes, the more you’ll pay in penalties. For failing to file, the penalty is 5% of your unpaid taxes for each month that a tax return is late (though this penalty is capped after five months, or 25% of your unpaid taxes). In addition to the failure to file penalty, there is a failure to pay penalty of 0.5% of your unpaid taxes per month (also capped at 25% of your unpaid taxes). Since the penalties accrue monthly and interest compounds daily, the amount will add up quickly.

In extreme cases, the punishment won’t just be a financial one. If you use illegal means (such as misrepresenting your income to the IRS) to avoid paying taxes, you might be guilty of tax fraud. The penalty for tax fraud can be as high as five years in prison and up to $250,000 in fines.

Your tax dollars pay for vital infrastructure, programs, and services that the federal, state, and local governments provide. On the federal level, just a few programs make up the vast majority of spending. Based on 2020 budget data, those programs are:

• Social Security provides monthly income for seniors and costs taxpayers more than $1,100B annually. The program is funded by a dedicated payroll tax (aka the Social Security tax).
• Medicare is a federal program that provides seniors health insurance coverage. The program costs more than $900B annually and, like Social Security, has a dedicated payroll tax.
• Medicaid provides health insurance coverage to low-income individuals and families, and costs about $450B annually.
• Defense spending costs more than $690B annually.

Other federal government spending includes transportation, education, health, housing, unemployment insurance, and veterans benefits.

In total, federal government spending represents more than 20% of the nation’s gross domestic product (GDP), which is the total value of goods and services that a country produces.

We also pay taxes to our state governments, which are responsible for delivering many essential government programs. One of the primary jobs of state governments is providing public education. As a result, K-12 education represents about 26% of state spending.

Another significant expenditure for state governments is funding Medicaid. The program is jointly funded by the federal government and state governments and administered by the state governments. It makes up about 17% of state government spending.

Other major state expenditures include higher education, transportation, corrections, and public assistance to families in need. Ultimately the spending numbers vary widely from one state to another, as each state has different needs and priorities.

In the United States, we have a progressive income tax system. The percent you pay in income taxes increases as your income level does. There are seven tax brackets with seven different tax rates. Individuals pay a particular rate on the portion of income that falls within a given bracket.

Here are the federal tax brackets in the US for 2022 (the taxes that are due spring 2023):

Here are the federal tax brackets in the US for 2023 (the taxes that are due spring 2024):

Suppose that an individual had $250,000 of taxable income in the tax year 2022. They would pay income taxes in six of the seven tax brackets. But each percentage would only apply to a portion of their income. For example, the 35% tax rate would apply only to the portion of their taxable income that was greater than $215,951.

Remember that it’s not just the federal government that levies taxes — State and local governments do as well. The makeup of state and local tax revenue looks very different than that of the federal government.

States rely heavily on sales taxes, individual income taxes, and fees for their tax revenue. Fees that state governments collect include university tuition, payments to public hospitals, and tolls on highways or bridges.

States also rely on intergovernmental transfers, meaning the money they receive from other state or local governments. Most state intergovernmental transfers come from the federal government to pay for welfare programs such as Medicaid.

Like state governments, local governments get a lot of their money from other levels of government. Most of their transfers come from the state government, while a smaller portion comes from the federal government.

Local governments also collect taxes directly. They rely most heavily on property taxes, sales taxes, and fees such as water, sewer, and parking charges.

Robinhood does not provide tax advice. Please consult with a tax professional regarding your personal circumstances.