For many Americans, filing income tax returns and paying taxes is a part of life. There is a reason, after all, that there is the existence of the phrase, “In this world, nothing is certain, except death and taxes.”  In 2023, the IRS received 162,037,000¹ individual income tax returns and issued $335 billion in refunds. As income tax season comes around again, you might be wondering how taxes work and which taxes you are responsible for paying.

For a lot of people, when they hear the word “taxes”, it’s income tax that immediately comes to mind. However, there are several other types of taxes that are assessed and paid over the course of a year and your lifetime. When you stop to really think about it, you might be surprised to find how many types of taxes you have the potential of being subject to over the course of time.

With that in mind, understanding the tax system and its potential cost can be very important to help individuals and businesses navigate their financial strategies to minimize the overall impact of taxes. An important part of long-term financial success lies in being efficient with your money to minimize taxes to the greatest extent legally possible.

What are taxes?

Simply put, taxes are the sum of money paid to the government to collectively fund spending towards public goods and services. Taxes are used to fund things like schools, roads, and various public programs, such as Social Security and Medicare. Citizens and corporate entities are all required to pay taxes, be it at the federal, state, or local level. We pay taxes to the government and entrust them to accomplish these positive impacts on society while using our tax dollars in an efficient manner.

Governments may levy various types of taxes, each serving a different purpose. There are also varying degrees to which the average person may be subject to them:
 

Income-based taxes: Taxes that are reported and paid on the annual income tax filings with the Internal Revenue Service:

• Income tax: a tax levied on the wages, salaries, investment income such as interest and dividends, or other forms of income an individual or household earns and receives.
• Capital gains tax: a tax levied on profit from the sale of property or an investment.
• Corporate income tax: a tax levied on the business profits of corporate entities.

Payroll taxes: Taxes paid on the wages and salaries of employees to finance social insurance programs. These taxes are withheld directly from your paycheck if you are a W-2 employee and paid through the income tax return if self-employed. They are made up of two components:

• Social Security tax: a 6.2% tax on earned wages with funds used for social security benefits paid to those eligible.
• Medicare tax: a tax of 1.45% on earned wages with funds used to pay for Medicare, Part A benefits.

Property taxes: Taxes based on the value of a property, paid by the property owner:

• Real estate taxes: a tax based on the value of your home.
• Vehicle/personal property taxes: a tax based on the value of your car, truck, boat, etc.

Consumption taxes: Taxes levied on the purchase of goods or services and is paid by the consumer:

• Sales tax: a tax applied to retail purchases, set at a percentage of the total cost that is determined at the state and local level.
• Tariff: a tax imposed by one country on the goods and services imported from another country.

Death taxes: Taxes imposed on a deceased’s estate:

• Estate tax: a tax levied on the transfer of the estate of a person who dies.  An estate tax applies when the value exceeds an exclusion limit set by law. 
• Inheritance tax: a state tax that you pay when you receive money or property from the estate of a deceased person.

Types of taxes

Income tax

Income tax is a tax levied on the wages, salaries, investments, or other forms of income an individual or household earns. This is one of the taxes where you can reduce your taxes due annually through pre-tax deductions, standard or itemized deductions and other credits that may be available depending on your specific circumstances.

The United States has a progressive income tax system where taxes are applied through marginal tax rates. This means that high-income individuals and corporations pay a higher percentage of their income in taxes, compared to low-income earners. As a result, the average tax burden increases along with a taxpayer’s income.

In addition to which marginal tax bracket you fall into, your filing status – whether you file as single, married filing jointly, married filing separately, or head of household – and the source of your income can also play a role in how much income tax you pay. This is because tax brackets vary between each filing status and sources of income can be taxed differently.

Read more: 2024 & 2025 tax brackets and federal income tax rates

It is also important to keep in mind that due to the progressive nature of the tax brackets, the marginal tax bracket that an individual falls into is higher than the effective tax rate they actually pay. The effective tax rate is the average tax rate paid on the total taxable income. In other words, if an individual falls into the 32% tax bracket, not all their income is taxed at 32%, only the amount of income over the bracket amount is taxed at that 32% rate.

An illustration might be useful to show the application of the tax brackets in action. For an example of how progressive tax works, let’s consider John and Jane.

Both are single but John has a net taxable income from wages of $100,000 for the year, while Jane’s net taxable income for the year from wages ends up at $200,000. For this illustration's purpose, the assumption is that the net taxable income is after all pre-tax deductions and standard or itemized deductions that may be available have been accounted for.

In this basic example, John’s total federal income tax would be $17,053, an effective tax rate of 17%. Janes total federal income tax would be $41,687, or an effective tax rate of 21%. The calculation of those taxes per the 2024 income tax brackets for single individuals are as follows:

• John’s income would place him in the 22% marginal federal income tax bracket in tax year 2024, however, not all his income would be taxed at 22% due to the progressive nature of the tax brackets. So, while his marginal tax rate is 22%, his effective tax rate would end up at 17%:
  • The first $11,600 would only be taxed at 10%, or $1,160; the amount from $11,601 to $47,150 would be taxed at 12%, or $4,266; and the amount from $47,151 to $100,000 would be taxed at 22%, or $11,627. Those three brackets accumulate for a total tax of $17,053 ($1,160 + $4,266 + $11,627), for an effective tax rate of 17%.
• Meanwhile, Jane’s income would place her in the 32% marginal federal income tax bracket in the tax year 2024, but just like John, not all her income would be taxed at 32%. While her marginal tax rate is 32%, her effective tax rate would end up at 21%:
  • The first $11,600 would only be taxed at 10%, or $1,160; the amount from $11,601 to $47,150 would be taxed at 12%, or $4,266;  the amount from $47,151 to $100,525 would be taxed at 22%, or $11,743; the amount from $100,526 to $191,950 would be taxed at 24%, or $21,942, and the amount from $191,951 to $200,000 would be taxed at 32%, or $2,576. Those five brackets accumulate for a total tax of $41,687 ($1,160 + $4,266 + $11,743 + $21,942 +$2,576), for an effective tax rate of 21%.

Read more: Progressive tax: Definition and examples

Capital gains tax

Capital gains tax is a tax levied on profit from the sale of property or an investment. When stock shares or any other taxable investment assets are sold, the capital gains, or profits, are referred to as having been realized, and capital gains tax is owed. The income tax is calculated and paid as part of the annual income tax filing.

Capital gains taxes fall into two categories: long-term capital gains and short-term capital gains.

• Long-term gains are levied on profits of investments held for more than a year. The long-term capital gains tax rates² for the 2023 and 2024 tax years are 0%, 15%, or 20% of the profit, depending on the income of the filer.
• Short-term gains are taxed at an individual's regular income tax rate, which is higher than the tax on long-term gains. Since most taxpayer’s income tax rate will be higher than the long-term capital gains tax rate, there is a financial incentive to hold investments for at least 1 year if it makes sense from an overall investment and diversification strategy.

Corporate income tax

Corporate income tax is a tax levied on the business profits of corporate entities. Corporate income tax is only paid on a company’s taxable income.

Since passing the Tax Cuts and Jobs Act of 2017, the federal corporate tax rate has been 21%. As part of the Inflation Reduction Act of 2022, Congress created the Corporate Alternative Minimum Tax (CAMT)³ and passed a new 15% minimum tax into law. The CAMT generally applies to large corporations with an average annual financial statement income exceeding $1 billion.

Payroll tax

Payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs, Social Security (old-age, survivors, and disability insurance) and Medicare (hospital insurance). These taxes are withheld from your paycheck by your employer. In 2024, employees will pay 6.2% into Social Security on the first $168,600 earned and 1.45%⁴ into Medicare on all wages.  

In addition, the employer matches and pays in the same 6.2% Social Security tax and1.45% Medicare tax, so the government receives a total of 12.4% Social Security tax.

High earners (individuals making more than $200,000 in a calendar year) will pay an additional Medicare tax of 0.9%.

Self-employed individuals are still responsible for paying these same taxes, though it works a little differently. Self-employment tax consists of Social Security and Medicare taxes for individuals who work for themselves. The self-employment tax rate is 15.3%⁵.

The rate consists of two parts: 12.4% for social security and 2.9% for Medicare. Essentially, because the self-employed individual is the employee AND employer, they are responsible for paying the entirety of the total tax due to the government. The employer portion of the tax is deductible as an expense from taxable income.

Real estate property tax

Property tax is a tax based on an assessed fee based on the value of a property, paid by the property owner. Property tax is an ad valorem tax, meaning that it is based on the assessed value of real estate – this includes land and any permanent structures on it. Typically, a property assessor appointed by the local government will determine the value of your real estate.

Calculating the amount you’ll pay in property tax each year is simple: take the assessed value of your home (you can usually find this on your county or local government’s website) and multiply it by the tax rate for your region.

Vehicle/personal property tax

In some states, a tangible personal property (TPP) tax is charged in addition to property taxes. The TPP applies to property that can be moved or touched, such as jewelry, cars, and boats.

Sales tax

Sales tax is a tax applied to retail purchases, set at a percentage of the total cost that is determined at the state and local level. It Is applied at the time of payment and the business remits the funds to the government.

Each state can implement its own sales taxes, meaning they vary depending on location. In Delaware, for example, there is no sales tax, while California has the highest sales tax rate at 7.25%.⁶

What’s more, some localities levy additional sales tax on top of the state rate, which can further increase the ultimate price consumers pay at checkout.

The types of goods and services that can be subject to or exempt from sales tax can vary by state and location as well.

Tariffs

A tariff is a tax imposed by one country on the goods and services imported from another country. Tariffs encourage consumers to make domestic purchases by increasing the price of goods and services imported from other countries.

There are several types of tariffs that a government can employ, including:

• Ad valorum tariffs: Tariffs levied as a fixed percentage of the value of the imports
• Specific tariffs: Tariffs charged as a fixed amount on each imported good
• Tariff-rate quotas: Tariffs that kick in or rise significantly after a certain amount of imports is reached

Tariffs can serve several goals. Like all taxes, they provide a source of government revenue, but they can also be used to help domestic industries or to retaliate against other countries.

Estate tax

Estate tax is a tax levied on the transfer of the estate of a person who dies. An estate tax applies when the value exceeds an exclusion limit set by law. Estate taxes are different from inheritance taxes in that an estate tax is applied before assets are disbursed to any beneficiaries.

Due to the relatively high exclusion limits, a large number of Americans’ estates are not currently impacted by the estate tax. However, those exclusion limits are subject to potential changes from new legislation, so the current tax law should be monitored on an ongoing basis.

If the gross estate does exceed the filing threshold for the year of death, a filing is required.  In 2024, the filing threshold is $13,610,000⁷, up from $12,920,000 in 2023. To take a basic example for illustrative purposes, if a person were to die in 2024 and leave behind an estate of $15,000,000, the estate would owe taxes on the net amount over the exclusion limits. Similarly to the income tax brackets, the federal estate tax rate is a progressive marginal rate that increases from 10% to 37%.

There are also a handful of states⁸ and the District of Columbia that impose a state estate tax. Those states are:

• Connecticut
• Hawaii
• Illinois
• Maine
• Maryland
• Massachusetts
• Minnesota
• New York
• Oregon
• Rhode Island
• Vermont
• Washington
• District of Columbia

Inheritance tax

An inheritance tax is a state tax that you pay when you receive money or property from the estate of a deceased person. Who is subject to inheritance taxes and how much they’ll pay varies by state. Each state has certain exemptions in place, just like the IRS does for the estate tax.

As of 2024, only six states levy an inheritance tax:

• Iowa
• Kentucky
• Maryland
• Nebraska
• New Jersey
• Pennsylvania

However, Iowa is phasing out its inheritance tax, with full repeal scheduled for 2025⁹. Of the six states with inheritance taxes, Kentucky and New Jersey have the highest top rate of 16 percent.

Read more: Taxes on inheritance & how to avoid them

Understanding how taxes work

What are taxes used for?

Taxes are used to collectively fund government spending towards public goods and services. Here are some of the ways taxes are used at the federal¹⁰, state¹¹, and local level:

Federal

• Social security
• National defense
• Health insurance, including Medicare, Medicaid, the Children’s Health Insurance Program (CHIP), and the Affordable Care Act (ACA)
• Economic security programs, such as the Earned Income Tax Credit and Child Tax Credit
• Benefits for veterans and federal retirees
• Interest on debt
• Education
• Natural resources and agriculture
• Science and medical research
• Law enforcement

State and local

• Public welfare programs
• Elementary and secondary education
• Health and hospitals
• Higher education
• Highways and roads
• Law enforcement
• Corrections
• Housing
• Courts

What day are taxes due?

The 2024 tax return filing deadline for income taxes for most U.S. taxpayers is Monday, April 15, 2024. Taxpayers who file for an extension have until Tuesday, October 15, 2024, to file their returns. However, it is important to keep in mind that an extension to file is not an extension to pay.  Even if an extension is filed, an estimated payment of any anticipated amount due needs to be paid along with the April 15th extension.  In other words, the total taxes due need to be paid no later than April 15th to avoid potential late payment penalties, regardless of whether an extension has been filed. 
 

Which government agencies enforce tax laws?

In the United States, there are federal, state, and local tax authorities. The Internal Revenue Service (IRS) is responsible for collecting most domestic federal taxes, including income tax.

Every state in the United States has its own tax administration, subject to the rules of that state's law and regulations. These authorities are referred to in most states as the Department of Revenue or Department of Taxation. Most localities also maintain a tax administration or share one with neighboring localities.

Tax delinquency

Each type of tax has a different due date and reporting requirements, so it’s important to understand your tax obligations to avoid delinquency. Some taxes, such as sales taxes or tariffs are collected immediately at the time of payments. Others, such as property or income taxes, occur on a fixed recurring schedule. For example, federal incomes taxes are due on the 15th day of the fourth month after the fiscal year ends—in 2024, this will be April 15t Due dates for the same types of taxes may differ across different governing bodies.
 

Penalties for tax delinquency

If you don’t meet your tax obligations on time, you may be subject to various penalties. The IRS charges a penalty¹² for various reasons, including if you don’t:

• File your tax return on time
• Pay any tax you owe on time and in the right way
• Prepare an accurate return
• Provide accurate and timely filed information returns

Tax penalties may include:

• A one-time fee or charge: A penalty assessment imposed as a flat fee
• An interest assessment: Escalation penalties based on the duration of the delinquency
• Lien on assets: Assets could be seized or a lien placed on assets if your debts aren’t paid
• Transaction-related consequences: Denial of access or service for certain taxes (e.g. tariffs)
• Business-related consequences: Seizure of company property or placing of liens due to business-related taxes

Tax evasion vs. tax avoidance

Tax evasion is illegal and involves deliberate misrepresentation to deceive tax authorities, while tax avoidance operates within the legal frameworks, using permissible methods to reduce tax liability. The IRS defines¹³ tax evasion as the failure to pay or a deliberate underpayment of taxes, and tax avoidance as an action taken to lessen tax liability and maximize after-tax income.

Examples of tax evasion:

• Not reporting income
• Exaggerating tax deductions
• Falsifying business expenses
• Hiding interest
• Purposefully underpaying taxes
• Filing taxes late

Examples of tax avoidance:

• Claiming deductions
• Claiming tax credits
• Minimizing your taxable income
• Aiming for lowest possible marginal tax rate
• Delaying tax liability by postponing income

Read more: How to reduce taxable income

Final note on taxes

Paying taxes is an important part of managing your finances. There are many types of taxes and specific requirements for each of them. Understanding which taxes apply to you and when and how you need to pay them is essential. If you have questions about your specific tax situation, reach out to a qualified tax professional for guidance and more information.

Remember to take our quiz to see how tax savvy you are.