The following is adapted from the “Your Money Vehicle” textbook.
Imagine this: On your morning drive to class, you drive over a pothole. That same pothole has been there for months, and no one has come to fix it. Then, you arrive at school to find that there are no teachers in the classrooms. At first, you are excited…but then start to wonder how you will ever graduate without them.
At the end of the day, you walk out to soccer practice and realize that the field has been cleared to make way for some new apartment buildings.
What is going on?
This bizarre day is an example of why we have taxes. Taxes fund just about everything between what you, I, or anyone else owns. Now that you appreciate a little of WHY we need taxes, let’s look at the first two taxes you will encounter: Sales tax, and income tax.
Let’s take a look at how these taxes work, where your tax dollars go, and when they’ll come out of your bank account.
Are taxes a good thing?
Different activities require different forms of taxation. Sales tax is charged when you buy something, such as a new pair of shoes. Income tax is charged when you earn money—so, if you get a paycheck.
How can we see taxes through a more positive lens? Well look at the events when taxes occur:
- You pay sales tax when you buy things
- You pay income tax when you earn money
- You pay capital gains tax when you create money through investments
It helps to remove the negative bias towards taxes by understanding why we need taxes and seeing them occur in positive events.
How does sales tax work?
When you purchase goods or services, there is generally a tax associated, the sales tax. It is imposed by state and local governments and supports those governments in a variety of ways. For example, when you go out to dinner and your meal costs $10, but the bill comes back saying you owe $10.65, the additional $0.65 is the tax associated with the sale of your dinner. It would be an effective 6.5% sales tax.
There are over 10,000 different jurisdictions that can charge a sales tax. Counties or large cities, such as Seattle, will have their own sales tax on top of their state’s sales tax. Let’s say you were to buy that same dinner in downtown Seattle. The bill would be $11.01 due to an extra $0.36 imposed by the city of Seattle on top of Washington State’s sales tax!
However, there are five states—Alaska, Delaware, Montana, New Hampshire, and Oregon—that do not charge a state sales tax at all.
What if you buy something online? As of a Supreme Court ruling in 2018, you are charged a sales tax based on your state of residence, no matter where you make a purchase—in a store or online. Don’t worry, your Amazon purchases won’t go up; Amazon has paid these taxes voluntarily since 2016.
Now, let’s talk about income tax, which tends to be a bit more complicated.
All about income tax
Imagine for a moment that you are about to pop your Thanksgiving turkey into the oven. Your crazy cousin, Ficano, asks, “How many pounds of meat is that? Because I want a pound to myself.”
As you silently wish Ficano had made other holiday plans, you remember that the label on the turkey had said 20 pounds. But before you put that twenty pounds of cooked turkey out on the table to eat, you will have to remove some of the parts that nobody’s going to eat, like bones.
Later, as you take the turkey out of the oven and begin carving for the table, you realize the family will only get to eat about 12 pounds of the turkey. You better tell Ficano to take it easy!
This concept of going from 20 pounds to 12 pounds is similar to differentiating gross income from net income. Only, in this scenario, the pounds you lose are income tax. A simple way to think about gross vs. net is that gross is the number on your contract and the net is the amount of money on your paycheck after paying to contribute to your retirement plan, paying taxes, and other deductions.
There are three major income taxes you’ll need to pay:
- Federal Income
- State Income
- FICA (Federal Insurance Contributions Act)
FICA is a federal payroll tax, which means it is automatically taken out of your paycheck. The tax taken out of your income goes toward supporting public services such as Social Security (retirement income), Medicare (healthcare), and children of deceased workers.
When you work for a company, they will issue you a W2 that summarizes the wages they paid you and the taxes that were taken out. The W2 is merely a reporting tool to inform the IRS of what you were paid and what elections you have made. The W2 does not decide your taxes; it is more of an estimate until you file your 1040. If you are self-employed, you will still have to pay these taxes and in fact, it doubles!
Typically, Tax Day is April 15. However, it can float a little if the 15th falls on a weekend or holiday. Just always be aware that it will be coming in mid-April.
Lastly, if you live in Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming, you don’t need to worry about a state income tax, because these states don’t have it. Enjoy the extra money you get to keep! But be on the lookout for higher sales tax rates.
Look at the bright side of taxes!
Remember, taxes pay for the library, schools, public transportation, and many of the other services we all enjoy. Would you want to live in a society that didn’t have these services? Probably not!
Taxes are almost always unavoidable for the average person, but by focusing on the positives and knowing how and why you pay them, you can make sure you file your taxes correctly and pay exactly what you owe—no more and no less.
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