How Does the American Tax System Work? (Tax System Basics)

The American tax system is a complex and intricate system that affects every individual and business in the country. The saying is true that there is only two things guaranteed in life, “death and taxes.” As you or your business will have to pay for years and years to come, it is important to understand how the tax system works in order to make informed decisions about financial planning. We’re going to go over the basics of the tax system and break down the American tax system at a high level to help you better understand how it works and how it affects you.

questioning american tax system

Who Pays Taxes in the United States?

All individuals and businesses in the United States are required to pay taxes. This includes citizens, residents, and non-citizens who earn income in the country.  The amount of tax an individual or business pays is determined by their income level, as well as other factors such as deductions and credits. 

You even earn taxes if you are an American living abroad and exceed the foreign-earned income exclusion set out by the IRS. It doesn’t matter where you live, as an American, the first thing to know is you owe taxes.

What is the Purpose of Taxes in the United States?

Taxes serve multiple purposes in the United States. The primary purpose of taxes is to fund the federal government, which uses the revenue to provide a wide range of services to the American people. These services include national defense, education, healthcare, and infrastructure. Does your kid go to a great public school? Taxes pay for that. 

 Taxes also play a role in redistributing wealth and promoting social equality, as they provide funding for programs such as social security, Medicaid, and other welfare programs. Everyone pays into social security early and expects to get money back out later.

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Federal vs State Taxes: The Difference

There are taxes at both the federal level and the state level. Federal taxes apply to everyone regardless of which state they live in or if they live abroad. State taxes can vary from state to state. 

This means you could strategically live in a state like Flordia with no income tax or plan for the states that give you the most tax benefits upon retirement. Picking a state based on taxes is one area that enough people don’t seem to take into consideration of their financial picture.

Types of Taxes in the United States

So now that we know who pays taxes and where those taxes go, let’s touch on some of the types of taxes in the United States.

Income Tax: This is the most well-known type of tax, and it is a tax on an individual’s or business’s income. The tax rate for income tax varies based on the amount of income earned. State income taxes also vary state by state.

Payroll Tax: This is a tax on an individual’s wages or salary. The tax is used to fund Social Security and Medicare. It doesn’t matter if you are self-employed or work for a company, this is another deduction.

Sales Tax: This is a tax on the sale of goods and services. Some states charge sales tax for clothes and groceries while others don’t. Sales tax rates vary by state and local government. 

Property Tax: This is a tax on an individual’s or business’s real estate. The tax rate is based on the value of the property. Some states will have cheaper housing but be careful because property tax can be much higher.

Estate Tax: This is a tax on the transfer of an individual’s assets after death. The tax rate varies based on the amount of assets transferred. A lot of Americans never breach the limit prior to estate tax being applied.

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How Does the Tax System Work in America?

explaining the american tax system to another individual

The American tax system is designed to be self-assessing, which means that individuals and businesses are responsible for reporting their own income and calculating their own taxes. Most individuals and businesses use a Certified Public Accountant (“CPA”) to help file their taxes. They also use CPAs to plan strategically and reduce taxes in future years.

 The tax system is also designed to be progressive, meaning that individuals and businesses with higher levels of income pay higher tax rates. Some people argue that rich people aren’t paying enough but they do pay more, for the more they earn.

Individuals and businesses file tax returns each year with the Internal Revenue Service (IRS), reporting their income, deductions, and credits. Again, most individuals and businesses lean on a CPA for making estimated tax payments and filing tax returns on time. 

The IRS then uses this information to calculate the amount of tax owed. If an individual or business owes tax, they must pay it by the tax filing deadline, typically April 15th. State taxes are generally due around a similar time but keep in mind states can set their own deadlines. If you think you can’t meet the deadlines, speak with a CPA to file an extension to file.

 When an individual or business is owed a refund, the IRS will issue a refund. It’s not necessarily a good thing to receive a tax refund even though many Americans look forward to a tax refund.

Final Thoughts on the Basics of the American Tax System

The American tax system is complex and we just covered the tip of the iceberg with understanding the types of taxes, who needs to pay and when. Planning ahead for taxes and reducing them strategically is one of the best ways to improve your income. Think about skipping Quickbooks for filing time and speaking to a CPA who can navigate the laws on your behalf.

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