Tax Basics You Need to Know

Taxes affect many parts of your financial life, from the income you earn to the things you buy and the property you own. Common taxes include federal income tax, state and local income taxes, payroll taxes, sales taxes, property taxes, and capital gains taxes. The types of taxes you pay, the rates charged, and the rules that apply can vary depending on where you live.

Taxes also influence financial decisions because governments use tax policy both to raise revenue and to encourage or discourage certain activities. This lesson provides a big-picture overview of the major types of taxes and how they can affect your finances.

Where Do Your Tax Dollars Go?

Tax revenue helps governments pay for many of the services and systems people rely on every day. Depending on the level of government, tax dollars may support:

• Roads, bridges, public transportation, and other infrastructure
• Police, fire departments, and other public safety services
• Public schools and education programs
• Social programs and assistance
• National defense
• Parks, libraries, and other public spaces and services

Taxes help fund public goods and services that benefit many people and would be difficult for individuals to provide on their own. Students may already use many tax-supported services regularly, including schools, roads, parks, libraries, emergency services, and public transportation.

Progressive versus Regressive Taxes

Taxes impact different people in different ways, and economists can classify different types of taxes based on whether they are Progressive or Regressive.

Progressive Taxes

A “Progressive” tax is designed so that the more money you earn, the bigger percentage tax you pay. The clearest example of a “Progressive” tax is federal income tax in the United States. This is the “tax bracket table” as of 2024:

What this means is that if you are a single person, your first $11,600 is taxed at 10%, then from $11,601 to $47,150 you are taxed at 12%, from $47,151 to $100,525 you are taxed at 22%, and so on. The more you earn, the more you are taxed. From this table, if you earn $125,000, your tax will break down to:

• First $11,600 taxed at 10%
  • $1,160 tax
  • $113,400 moves up to the next bracket
• The next bracket is $11,601 to $47,150, or your next $35,500. This is taxed at 12%
  • $4,266 tax
  • $77,850 moves up to the next bracket
• The next bracket is $47,151 to $100,525, or your next $53,357. This is taxed at 22%
  • $11,742 tax
  • $24,475 moves up to the next bracket
• The next bracket is the money you made over $100,526, meaning that last $24,475. This is taxed at 24%.
  • $5,874 tax

This would make your total income tax $1,160 + $4,266 + $11,742 + $5,874 = $23,043 (or about 18% of your total income).

If you only earned $8,000 for the year, it would just be $8,000 taxed at 10%, so you can see that as your income goes up, so does your tax rate.

This type of tax is usually popular, as it shifts most of the tax burden onto people who can most easily afford to pay it (while giving the poor a tax break).

Regressive Tax

A “Regressive” tax is the opposite, the smallest earners pay the biggest percentage of tax. An example of a “Regressive” tax is a sales tax, where you pay a flat percentage fee on everything you buy. This might not sound regressive at first, but consider our two earners from the example above, with a 5% sales tax.

• Our $100,000 earner saves 30% of their earnings, between their investments and their retirement account. They only spend $70,000 per year.
  • A 5% sales tax on $70,000 is $3,500.
  • This comes out to a 3.5% tax on their total earnings.
• Our $8,000 earner is too poor to set aside any money for savings. They spent all $8,000 that they earned.
  • A 5% sales tax on $8,000 is $400
  • This is exactly 5% of their total earnings

Our “richer” person is paying a lower total percent tax than our poorer earner, which is what makes this tax “regressive”. All “use taxes”, like vehicle registration fees, gasoline taxes, sales taxes, taxes on cigarettes and alcohol, and even things like fishing permits are “regressive” taxes.

Regressive taxes are also popular in all the examples outlined above because it shifts the burden of the taxes on the people who use these services. For example, gasoline taxes are used to fund road maintenance, which means people who buy the most gas (and use the roads the most) pay more for their maintenance.

Proportional Taxes

A proportional tax, sometimes called a flat-rate tax, applies the same tax rate to everyone subject to that tax, regardless of income level. For example, if a tax applies a flat 5% rate to a particular tax base, someone with $20,000 of taxable income would pay 5%, and someone with $100,000 would also pay 5%.

Taxes on Your Financial Decisions

Your potential tax burden can have a major impact on your financial decisions as well because lawmakers design tax structures to encourage certain types of activity and discourage others. Some examples of this include:

Capital Gains Taxes

“Capital Gains” tax is the tax placed on appreciated assets. A clear example of this is the profit earned from investing in stocks.

Capital Gains taxes are structured with two rates, a “Short Term” rate for profits earned in less than a year, and a “Long Term” rate for profits earned over more than a year. What determines the timeline is when you sell your asset and collect the cash profit, not just how much the stock goes up in value while still in your portfolio. In 2024, these were the capital gains tax rates for a single person (note that this is a “Progressive” tax, so the rate increases as profit increases)

Income from wages and salaries is earned by working, while interest income is earned from sources such as savings accounts or bonds. Capital gains, by contrast, generally occur when you sell an investment or other asset for more than you paid for it.

For more information about taxes on tips, freelance work, side income, and other income that may not be obvious, see Uncovering Hidden Income Taxes You Owe.

Tax Rates for Short-Term Capital Gains

If you have profits from short-term capital gains, it is treated as regular income when filing your taxes – so it gets added to your other income and uses the same tax rates.

Tax Rates for Long-Term Capital Gains

The government likes to encourage long-term investments, particularly as part of a retirement plan, so low profits are not taxed at all. On the contrary, high profits are taxed at a MUCH lower rate.

As an investor, this can have a major impact on your investing decisions. Encouraging long-term investing means that you would be less likely to sell off a stock just because it has one or two “bad days” because the short-term capital gains tax would eat into your profits. If you hold a stock for more than a year before selling it, you get to keep a lot more of your profits.

Sales Taxes

Sales taxes can also discourage your purchases or encourage you to make your purchases elsewhere. For example, most cities have high sales tax rates, which adds extra expenses to every purchase. Many suburban areas (just outside the cities) have many “outlet malls”, where retailers set up shop just outside the city to lure shoppers out for the lower prices (purely due to lower sales tax).

Cities also put higher taxes on vehicles in suburban and rural areas. This is specifically to discourage people from buying cars and clogging up the roads and to encourage people to share rides or use public transit.

Property Taxes

Property taxes are taxes based on the assessed value of certain property, most commonly a home or land. Depending on the state or local government, taxes may also apply to certain personal property, such as vehicles.

The amount owed is generally based on the property’s assessed value multiplied by the applicable property tax rate. Property tax bills may be paid annually, semi-annually, or through monthly payments collected with a mortgage, depending on the location and arrangement.

For example, suppose a home has an assessed value of $250,000 and the property tax rate is 1.2%:

$250,000 × 1.2% = $3,000

The annual property tax owed would be $3,000.

Property taxes can be an important consideration when buying a home or other property because the tax cost may continue for as long as you own the property.

Estate Tax

An estate tax may apply when wealth and property are transferred after someone dies. At the federal level, the tax generally applies only to estates above a relatively high exemption threshold, so most estates do not owe federal estate tax. Some states may also have their own estate or inheritance taxes.

Excise and Luxury Taxes

An excise tax is a tax placed on specific goods or activities rather than on purchases generally. Common examples include taxes on gasoline, tobacco, and alcohol. Some governments may also impose special taxes on certain high-cost or luxury goods.

These taxes can raise government revenue while also discouraging the purchase or use of certain products.

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