Taxes
Federal, state and local governments collect taxes to provide citizens with a variety of benefits and services. Although federal income taxes are levied in all 50 states, state and local income taxes vary depending on where you live.
The IRS is the agency responsible for enforcing the federal tax laws and collecting the taxes owed. Taxes are generally charged when someone receives or gives money or property, and the majority of U.S. citizens must file a federal tax return each year.
Types of Taxes
Although the most common form of federal tax is income tax — tax collected on money people and businesses earn— many forms of taxation exist. Here are some other taxes the federal government collects:
- Employment tax: In addition to income tax, employment tax applies to Medicare and Social Security taxes deducted from employee paychecks. Employees and employers pay equal portions.
- Self-employment tax: In addition to income tax, self-employed individuals must pay both their portion of Medicare and Social Security taxes as well as the portion that an employer would normally pay.
- Gift tax: A gift tax applies to high-value gifts you make without expecting anything in return.
- Estate tax: The estate tax applies to high-value gifts you make upon your death, such as money and property bequeathed to heirs.
Filing Taxes
Although the IRS still accepts paper tax returns, filing your taxes electronically is arguably the simplest method. For example, with IRS e-file, there’s no guesswork. The system determines which tax form you need and takes you step by step through the filing process. Other electronic tax software programs can also help you claim your dependents and figure your taxes, credits and deductions.
Whichever method you choose, make sure you file your taxes and pay what you owe by the annual deadline or you will be charged interest and a late-payment penalty.
Tax Deductions and Credits
To lessen your tax burden when filing your income tax return, you can take advantage of various deductions and credits that might be available to you. Tax deductions are subtracted from your gross income, and tax credits are subtracted from the amount of tax you owe — and both reduce your overall tax liability. Tax credits aren’t as common as deductions and are often based on qualifying events, such as:
- The birth or adoption of a child
- A home purchase
- Caring for a dependent, which can include qualifying adult dependents
Two types of tax deductions exist — standard and itemized — but you can only use one of them when filing. The standard deduction is based on your filing status and is subtracted from your adjusted gross income. To benefit from itemized deductions, the total amount of your deductions needs to exceed the standard deduction amount.
Tax-Deferred or Tax-Free Investment Accounts
Investing money now as a way to finance your retirement can be a wise financial move, and two types of retirement accounts exist to help you meet your goals: tax-deferred and tax-free. Tax-deferred accounts allow you to contribute funds before you pay a tax on them. Later, when you retire and withdraw the funds, you’ll owe taxes. Examples of tax-deferred accounts include:
- Individual retirement account
- SIMPLE IRA
- 401k
- 403b
- 457
A less common method of saving for retirement is via tax-free retirement accounts. When utilizing these accounts, your contributions are made after taxes are taken out, which means you won’t have to pay taxes when you withdraw the funds later. Here are some examples of tax-free retirement accounts:
- Roth IRA
- 401k or 403b plans with Roth features
A retirement account such as a 401k with Roth features is considered both tax-free and tax-deferred. The tax-deferred status applies if your employer pays matching or profit-sharing contributions because taxes will not be taken out of those types of contributions until you decide to spend the funds.
To choose the best account for you, assess which one can get you the highest contribution or match from your employer and which one will cost you the least in taxes in the long run. You’ll also want to consider the investment options and fees associated with the account.
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