Starter Guide Explaining US Tax Basics
While no-one enjoys paying their federal taxes, the bottom line is that without them, crucial services like roads, hospitals, schools, government employees, the military, national parks and more would not be able to function.
This guide will explain some of the most important basics of US federal tax so you can better manage your finances.
Overview of Federal Taxation in the US
The United States is a federal republic with autonomous local and state governments, so taxes are imposed on all of these levels. This includes tax on your income, property, sales, imports, payroll, and estate, plus various additional fees.
Congress and the President are responsible for writing and approving the tax laws, while the Internal Revenue Service (IRS) enforces these laws, collects the taxes, processes tax returns, issues tax refunds and gives the money collected to the US Treasury. The Treasury then uses the funds to pay for various government expenses.
In addition, Congress and the President are also responsible for the federal budget, meaning the amount that the government plans to spend on various services and programs. If the government overspends, it will need to raise more money through taxes. And when the government spends less money, it can afford to lower taxes.
Important Basics of the US Tax System Explained
Everyone, whether a US citizen or not, is subject to federal taxation while living in America. The amount of taxes you owe will be largely based on your income, and you’ll pay your taxes throughout the year on a pay-as-you-go system. People who earn more income have higher tax rates than those who earn less, and your tax rates will increase the more you earn. The good news is that you can reduce your taxes by taking advantage of various tax benefits. To help you take control of your tax situation, let’s explore these key elements of US taxation:
‘Subject to Income Tax’
This term means that every person, company, organization, or even non-profit must pay a portion of tax based on their earnings. In other words, everyone must report their income amount and calculate the tax they owe the IRS. While some organizations are exempt from income tax, they still have to file a return and if they fail to meet certain criteria, their tax-exempt status can be revoked.
Meaning of Taxable Income
In short, income amounts to any money you earn because you worked for it or invested for it. This includes wages, interest, dividends, profits on your investments and pensions you receive. Income does not include gifts however – you will not be taxed on any gifts you receive, such as an inheritance or scholarship.
‘Pay As You Go’
The term ‘pay as you go’ means you pay your taxes throughout the year – for many people what this amounts to is that our income tax will be automatically taken out of your monthly paycheck and sent directly to the federal government. At the end of the year, if you’ve paid more tax than what you owe the IRS based on your income for the year, the government will give you a tax refund to balance the scales. The downside though is if you haven’t paid enough tax, you’ll have to pay an outstanding balance, which will be due by April 15th (the end of the tax year). And if you don’t make your payment by this due date, you’ll be charged interest and penalties on the amount you owe.
Progressive versus Flat Taxation
The tax system in the US is currently progressive. This means, as explained above, that your tax rate will change depending on how much money you make each year – people who earn more income pay higher taxes, while people who make less money have a lower tax rate. There is an ongoing debate however about whether tax rates should be progressive (dependant on what you earn) or flat (everyone pays the same tax rate). Politicians who support a flat tax say that a single tax rate for everybody will significantly simplify people’s lives. But politicians who support progressive tax rates argue that it wouldn’t be fair to ask a person with a relatively low income to pay the same percentage of tax as a wealthy person.
Tax Benefits
The concept of fairness is what tax benefits are based on. This is how Congress rewards people for making good financial decisions – tax planning, or choosing the right tax benefits, can save you alot of money. For example, if you contribute money to a retirement account, such as a 401(k) or IRA plan, you can reduce your total income which will then reduce the income tax you owe.
Voluntary Taxation
When saying that the income tax system is voluntary, this does not mean that the tax laws don’t apply to you if you decide you don’t like them (if only!). What it does mean is that you’re free to arrange your finances in such a way as to take advantage of tax benefits. In other words, you can choose to pay less tax by managing your money so that the amount of tax you owe is minimised.
Conclusion
The above guide gives you some key basics to help even beginner’s deal with US federal tax. If you work for an employer and don’t have investments, your pay as you go taxes will be easy to handle. But if your finances are more complicated, such as if you’re self-employed or have a portfolio of stocks and shares, it’s a good idea to consider a tax specialist to boost your chances of a refund and to make sure you don’t get into trouble with Uncle Sam.
About the Author: Bob Goren is an independent accountant and US federal tax advisor.
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