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Types of taxes: Understanding what you pay and why

At a glance:

  • Taxes on your income

  • Taxes on the things you buy, own, or do

  • Taxes on your investments

  • Income taxes on retirement plan distributions

  • Taxation of Social Security benefits

  • Penalty taxes on retirement plans

  • Summary of understanding the taxes you pay

  • Practical ideas you can start with today

Ever wonder what all those taxes out of your paycheck are for? You should.

We pay taxes in return for important services—Social Security, streetlights, military protection, schools, and to help support utilities. Let’s look at the major types of taxes that we pay in our lives.

Taxes on your income

Of all the taxes that we pay, income taxes are the most familiar, because we see them taken out of our paychecks.

Payroll withholding taxes include federal, state, and local income taxes, federal and state unemployment taxes, and Medicare and Social Security taxes. They are automatically taken out of your paycheck every time you are paid, based on a flat, fixed tax rate, formula, or table for state and local income taxes and Medicare and Social Security taxes.

For federal income taxes, the withholding amount depends on wages, your tax filing status and the number of withholding allowances you designate when you fill out federal tax withholding forms.

Employers pay the taxes that fund unemployment insurance payments on both the federal and state levels. These programs are known as FUTA (Federal Unemployment Tax Act) and SUTA (State Unemployment Tax Act) for the legislation that authorizes the collection of unemployment taxes. Employees do not contribute to FUTA and SUTA.

Federal and state taxes

Federal tax rates vary depending on your net income and filing status. The tax filing status can be married filing jointly, qualifying widow or widower, head of household (a separated, divorced, or single person who resides with one or more dependents), single, and married filing separately.

Married persons can either file jointly or separately. Taxpayers can claim head of household status if they have one or more qualified dependents living with them during the tax year.

Social Security and Medicare taxes

Social Security and Medicare payroll taxes—also known as FICA taxes—have been 6.2 percent each for employers and employees for Social Security, and 1.45 percent each for Medicare. Both the employer and employee pay Social Security taxes on the employee's wages up to $137,700 in 2020. (There is no limit to the amount of wages to which the Medicare tax applies.)

Once that limit is reached, no more taxes are withheld for Social Security for the rest of the calendar year; an additional 0.9% Medicare surtax is withheld on earned income above certain thresholds (but not matched by employers). Withholding of FICA taxes is resumed at the beginning of the new calendar year. The Social Security withholding limit is indexed for inflation.

Taxes on the things you buy, own, or do

When you think about taxes, the federal income tax usually springs to mind, because it is usually the biggest tax you pay in a year and it takes the most work to figure it out. But that's only where taxing begins.

There are many other taxes that you might pay on things you buy, own or do, such as sales tax on a big-screen TV or computer; property tax on your home; estate or inheritance taxes when someone dies; or the taxes on gasoline, phone, and utility bills.

Not everyone pays all those taxes because some states don't levy some of these taxes.

Sales tax

Sales taxes are levied on purchases of goods and services. Five states—Alaska, Delaware, Montana, New Hampshire and Oregon—don't levy a state sales tax rate, though in some cases local governments can implement a sales tax. State and local sales tax rates can vary significantly from place to place.

States vary in terms of what items are taxed. Most states exempt groceries from sales taxes, and some also exempt clothing or limit taxes on clothing in some fashion. Taxes imposed on business services and business to business also depend on the state.

Property tax

Property tax typically includes a home, but may also include other high-value items such as a car. Property taxes are typically based on an assessed value of the item in question, but there is no national standard on assessed values.

For homes, communities typically reassess property values periodically. That can either raise or lower your property taxes, depending on local property values and any improvements you've made to your home. Localities and states may also increase property taxes to pay for community services, such as adding police officers, building new schools, or just to cope with rising expenses.

Property tax rates range from the extremely low in states such as Alabama and Louisiana to very high in some New York and New Jersey counties. Besides property taxes on homes and cars, many localities assess property tax on vacant land and business and farm property.

A woman picks up tax forms in the lobby of the Farley Post Office in New York City. (Photo: Chris Hondros/Getty Images)
A woman picks up tax forms in the lobby of the Farley Post Office in New York City. (Photo: Chris Hondros/Getty Images)

Estate and gift taxes

Estate and inheritance taxes are paid when a person dies and has a specific amount of assets. The recent tax law changes the 2020 exemption to $11.58 million for individuals and $23.16 million for married couples.

Gift taxes may be due when you give money or property to others. In 2020, you can give up to $15,000 each year to someone else without either party having to pay gift tax.

Over your lifetime, you can give up to $11.58 million in gifts above the annual exclusion without those gifts being taxed; however, the total exclusion for gifts and estates is a combined $11.58 million, so if your combined gifts and estate are worth more than that amount, tax may be due.

In addition, some states have an estate tax, and a few states have an inheritance tax that beneficiaries must pay on property they inherit. Estate, inheritance, and gift taxes frequently change, so check with an attorney in your state regarding potential taxes when you are preparing a will.

Other taxes

If you've ever read your utility, cable or cell phone bill, no doubt you've noticed taxes on those services paid to the federal and, in some cases state, governments.

Like other taxes, those vary depending on where you live. Many other services also carry taxes, such as airline travel, hotels, and car rentals.

The gasoline tax is one way the state and federal governments collect revenue that is used to maintain and build infrastructure such as highways, bridges, and tunnels.

You may not notice this tax, because it isn't broken out at the gas pump, but it exists.

Taxes on your investments

Besides knowing how investment earnings are paid out, it is important to know how your earnings will be taxed.

How interest is taxed

Interest on bonds, certificates, and savings accounts is taxed as ordinary income unless the investment is tax exempt or deferred— as it is with many retirement accounts and municipal bonds. Interest of most municipal bonds issued by states and their subdivisions is generally free of federal income tax and also generally free of those states' income taxes, if any. That said, income from tax-exempt municipal bonds or municipal bond funds may be subject to other state and local taxes, and for certain bonds may be subject to the federal alternative minimum tax for certain investors. Federal income tax rules will also apply to any capital gains. US government bonds are free of state taxes.

How dividends are taxed

Ordinary dividends are taxed at the taxpayer's ordinary income tax bracket.

Certain qualified dividends, however, are taxed at the lower capital gains rates: 0%, 15%, and 20%, depending on the amount of taxable income.

How short-term capital gains are treated

Short-term capital gains, which are gains on investments that are held for a year or less, are taxed at your ordinary income tax rate.

How long-term capital gains are treated

Capital gains on investments that are held for more than a year (called long-term capital gains) are taxed at a lower rate than most other forms of income.

Prior to the new tax law that took effect in 2018, net long-term capital gains were taxed at 20% for taxpayers in the 39.6% tax bracket, and 15% for taxpayers in the 25% to 35% brackets. For those in the 10% and 15% brackets, long-term capital gains were taxed at 0%.

The new law establishes income levels rather than tax brackets for both long-term capital gains and qualified dividends. These income levels also differ according to filing status; the chart below shows the levels for a single person.

This Wednesday, Feb. 13, 2019, in Zelienople, Pa., shows schedule D for form 1040 and instructions printed from the Internal Revenue Service web page that are used for 2018 U.S. federal tax returns. As if the worst year for stocks in nearly a decade weren’t bad enough, many investors now have to pay a tax bill on top of it. The headache for investors is a result of how mutual funds are structured and how many times the funds’ managers bought and sold shares through 2018. Because of the way tax laws work, the majority of investors with a U.S. stock mutual fund or ETF received something called a “capital-gains distribution” late last year. (AP Photo/Keith Srakocic, File)
This Wednesday, Feb. 13, 2019, in Zelienople, Pa., shows schedule D for form 1040 and instructions printed from the IRS. (Photo: AP Photo/Keith Srakocic, File)

Net investment income tax

A 3.8% net investment income tax applies to certain net investment income of high-income individuals, estates, and certain trusts. For individuals, the tax generally applies to taxpayers who have certain investment income (such as interest, dividends, capital gains, etc.) and also have more than $200,000 of modified adjusted gross income if single taxpayers, or $250,000 if married taxpayers filing jointly

You can deduct net capital losses

Another important tax implication is centered on capital losses—the opposite of capital gains. If you lose money on your investments, you may be able to deduct up to $3,000 of your losses in excess of any capital gains from your taxable ordinary income. Losses over $3,000 may be carried over to future years.

This explains why so many people sell their stocks in December. Investors often choose to unload securities that are losing money in December in order to offset capital gains realized elsewhere in their portfolio and incidentally take advantage of this deduction on their income tax forms.

Income taxes on retirement plan distributions

While your life will undergo many changes when you retire, one thing that won't change is your obligation to pay taxes. Understanding how taxes affect retirement income can keep you from paying more than you need to.

How taxation works

Payments you receive from ordinary qualified retirement and IRA accounts are taxed at regular income tax rates upon withdrawal. They are added to your total yearly income and then taxed at the rates that apply to your income tax bracket.

If you have earned income or significant income from sources other than your retirement plan, your retirement plan distributions may put you in a higher tax bracket than when you were working.

To avoid this extra taxation, many retirees put off taking retirement plan distributions until the mandatory age of 70½, hoping that by then they will be in a lower tax bracket. Until then, their retirement nest egg continues to grow tax deferred.

The effect of taking a lump sum

If you wish to receive all of your retirement distributions in the same year (as a lump sum), you may find yourself in a higher tax bracket and paying more taxes than you would if you spread out the payments.

However, if you were born before 1936, you can use the 10-year averaging option to reduce the burden. With the 10-year option, you'll still have to pay all your taxes when you take out the lump sum, but the tax bracket will be calculated as if you took the distribution in equal payments over a period of ten years.

Alternatively, you may be able to roll over a lump sum distribution from an employer-sponsored retirement plan into an IRA tax-free. This gives you more flexibility in taking taxable distributions later.

The effect of taking minimum distributions

Another way to limit taxes from retirement distributions is to take minimum distributions. If you must draw from your retirement plan before age 70½, you should limit your withdrawals to just the amount of cash you need for expenses and the additional taxes. In years when you have larger tax deductions against income, you can take larger retirement distributions that will be offset by these deductions.

For example, if you plan to make large charitable donations or if you have business or investment losses that can offset ordinary income in a given year, that would be a good year to take a larger retirement plan distribution.

As you can see, your tax situation in retirement may become even more complicated than while you were employed. Take the time to understand how the tax code affects your retirement plan withdrawals; it could keep more of your money in your pocket.

Taxation of Social Security benefits

Just because your Social Security income is coming from the government, don't assume the government won't want some of it back! For many people, at least some of their Social Security benefits will be subject to taxes.

Two types of income

The IRS makes a distinction between two types of income for tax purposes. Earned income is all the income you get from working, including any wages you make as an employee or any net earnings from self-employment. Unearned income includes investment interest, capital gains, and dividends.

In 1984, Social Security benefits became partially taxable if you had yearly income that exceeded certain limits. Retirement plan distributions can lead to higher taxes on your Social Security benefits as well, by pushing you over those limits.

Income limits

If your combined income is less than $25,000 ($32,000 if married filing jointly) including adjusted gross income, non-taxable interest, and half of Social Security benefits, then your Social Security benefits are generally not taxed.

If your income, prior to retirement plan distributions, already has you paying maximum tax on Social Security, then the distributions will not make it worse. However, if you live on income below $25,000 ($32,000 for married, filing jointly), then you should consider the effect of taking distributions from your retirement accounts.

If you are below normal (or "full") retirement age, but have begun drawing Social Security benefits while still working, there is a factor to consider in addition to taxation: there is a limit to how much you can earn without decreasing your Social Security benefits while you work.

Here is how it works

Normal retirement age varies from age 65 to age 67, according to your year of birth. (The Social Security Administration has a handy online chart and calculator.) Persons born in 1955, for example, turn 65 in 2020.

They have a normal retirement age of 66 years and 2 months. (Retirement before "normal retirement age" is allowed as early as age 62, but with a substantial reduction in benefits. Retirement after this age increases benefits, up to age 70.)

Benefits lost

If you are below normal retirement age for all of 2020 and you receive Social Security benefits and you're still working, you lose $1 in Social Security benefits for each $2 you earned above $18,240. If you reach normal retirement age during 2020, your Social Security benefits will be reduced for the months in 2020 before full retirement by $1 for each $3 you earn above $48,600.

Starting in the month you reach normal retirement age, you will begin receiving full benefits for the rest of your life, no matter how much you earn. These benefits may still be taxable, however.

Penalty taxes on retirement plans

It seems that no matter what you do with your retirement money, there is a tax penalty lurking around a corner. Retirement plans have limits to the amount of money you can contribute to them annually.

For individual retirement accounts, this amount is a relatively tiny $6,000 for 2020. If you are age 50 or above before the close of the taxable year, you may contribute an additional $1,000. If you contribute more than you are allowed to, you will be assessed a 6 percent excise tax on the excess amount and its earnings.

If you try to withdraw funds from your retirement account before you turn 59½, you may be subject to an additional 10 percent penalty.

Caution on distributions

You must begin receiving distributions from most retirement plans by April 1 of the year after you turn 70½.

However, waiting till the year after you turn 70½ to begin taking distributions could result in extra taxes for that year because two distributions will be required in the same year—one for the year in which you turned 70½ and one for the current year. If you take out too little, you will be hit with a 50 percent penalty on the difference between the required minimum distribution and the amount you actually withdrew.

You must withdraw your minimum distribution by December 31 in any year distributions are required.

As you can see, you can save a considerable amount of money if you know and follow the rules for avoiding tax penalties.

Summary of types of taxes

There's not much way around taxes. Though we gripe about paying them, we also know that they are necessary. But that doesn't mean you need to pay more than you are legally obligated to. The government allows for tax-reduction strategies, as long as they are legal.

Here are a few ideas to get you started on thinking about your taxes.

Practical ideas you can start with today

  • Adjust the withholding of taxes on your W-4 if you want to avoid owing money at tax time. Ask your employer for help with this.

  • Estimate how much taxes and inflation can reduce your investment income.

  • Compare the benefit of a tax-deductible traditional IRA with a Roth IRA.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Taxes section

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