The (very) basics of taxes

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Taxes. Nobody likes them, but nearly everyone pays them in some way.

Taxes pay for important programs such as:

  • Social Security
  • Medicare and Medicaid
  • National defense
  • Police, fire and emergency medical services
  • Road construction and maintenance
  • Public education
  • Federal, state and local parks
To help you understand how the taxes you pay can affect your income, let's explore the types of taxes most people typically pay.

4 common types of taxes

1. Payroll taxes

Your employer withholds certain taxes from your paycheck and pays them directly to the government for you. That includes income, state and federal unemployment and Federal Insurance Contributions Act (FICA) taxes. FICA is the biggest payroll tax and goes toward funding Social Security and Medicare.

2. Sales taxes

When you buy a product or service, you usually pay a sales tax, depending on the state where you live.1 Sales taxes may be charged at both the state and local level. You pay the tax when you make a purchase, and the retailer sends it to the governments you owe. Many states exempt most types of food from sales taxes. If you buy a product or service online, whether the merchant collects sales tax depends on state and local laws.

3. Property taxes

If you own a home, you probably have to pay property taxes based on its value and location. States set guidelines for how local governments can impose these taxes, which are often paid to cities, counties, school districts and water districts. You may also pay an annual property tax on your car, which your state may use to help pay for public services like libraries and fire departments.

4. Income taxes
The federal government as well as most state and some local governments charge taxes on income.2 You may be taxed on income such as:
  • Salaries, wages, bonuses and tips from a job
  • Business or self-employment income
  • Interest, dividends and capital gains from investments
  • Money withdrawn from traditional retirement accounts
  • Alimony
  • Unemployment benefits
  • Social Security (if your income is above certain limits)

How tax brackets work

America's income tax system is complex, with rules and policies that often change as political control in Washington, D.C. changes.

One thing that generally stays the same is that your income is taxed "progressively." That means as your income reaches higher tax brackets, your tax rate goes up as well. The federal tax rates are divided into seven brackets based on your filing status. There are five filing status options, depending on your situation and whether you're married or single.

The highest tax bracket your income falls into is known as your "marginal" tax rate. However, not all your income is taxed at the highest rate. Only the money you earn within a specific tax bracket is taxed at that rate

Let's take a closer look at how progressive taxation works by imagining that you're single and earning $40,000 a year in taxable income. As shown in the chart below, for tax year 2023 you'd pay 10% in taxes on the first $11,000 of your income and 12% on the remaining $29,000. Your marginal tax rate would be 12%, because it's the highest tax bracket for your income.

Marginal income tax brackets for tax year 2023 for single filers

Marginal income tax brackets for 2023 for single filers. Tax rate 10% is $11,000. Tax rate 12% is $44,725. Tax rate 22% is $95,375. Tax rate 24% is $182,100. Tax rate 35% is $578,125. Tax rate 37% is $578,126+

Source: "IRS provides tax inflation adjustments for 2023," October 28, 2022

Note: These are federal income tax figures; state income tax rates vary, and you don't have to pay an income tax in some states.1

Keep in mind this is a basic explanation of how taxes work. It doesn’t account for all filing status options, tax deductions, credits or exemptions. You may be able to take advantage of certain tax breaks to help reduce your taxable income year to year.

One way to potentially lower your tax bill is contributing to your employer-sponsored retirement plan and increasing your contributions as your wages grow.

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[1] Nine states — Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming — don’t have a state income tax. However, these states’ sales, fuel and property taxes may be higher than in other states to make up for the lack of income taxes.

[2] When you file local, state and federal tax returns, you may owe additional tax if you didn’t pay enough, or you may get a refund if you overpaid.