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How Does The US Tax System Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 10 minute read

Millions of Americans dread the April 15 tax filing deadline (May 17, 2021, for the tax year 2020), either because they detest the trouble of doing their taxes or because they fear the ensuing tax burden.

However, a number of important programs are funded by federal taxes, such as Social Security, Medicare, Medicaid, and the Children’s Health Insurance Program. 

Taxes also fund other programs that you might not think about, but that you rely on every day, like science and medical research, defense and international security, roads, and public transportation. Even if you dislike paying taxes, there are a few important things you should be aware of.

Important Tax Information

Taxes might be a hassle, but there are some cool things to know about them. Some of them could even help you save cash.

1. Income taxes are not paid by everyone

It’s hard to realize that nearly half of all Americans owe zero in federal income taxes. A tax return may not even be required of some people. Most persons who don’t pay taxes have very modest incomes; this includes people who are just starting out working and people who are retired and living off of Social Security. 

However, a sizable portion of those individuals does in fact pay some form of tax, whether it be federal, provincial, or municipal.

In the United States, taxpayers are not required to report income if it is below a certain threshold. For most people, that minimum is the same as the standard deduction for their filing status, but it’s significantly lower for married couples who file separately.

Instructions for Form 1040 list the following income limits for filing in 2020:

Filing StatusAgeMinimum Gross Income
Single filersYounger than 65$12,400
65 or older$14,050$24,800
Married filing jointlyYounger than 65 (both spouses)$24,800
65 or older (one spouse)$26,100$5
65 or older (both spouses)$27,400$5
Married filing separatelyAny$5
Head of householdYounger than 65$18,650
65 or older$20,300$24,800
Qualifying widow(er)Younger than 65$24,800
65 or older$26,100$24,800

Assuming no one claims you as a dependent on their tax return, the following figures apply. The regulations change if another person can use you as a dependent on their tax return.

In order to determine whether or not you meet the requirements for filing, please refer to Chart B of the Form 1040 instructions provided by the IRS.

It is possible that no taxes are owed by those who file a return. With all the deductions and credits you can claim, your taxable income might be reduced to zero or you might even get a refund on top of what you’ve already paid in through withholding or anticipated taxes. 

These refundable tax credits, such as the earned income tax credit and the child tax credit, are especially helpful for low-income households.

2. You Are Able to Take a Tax Holiday

The federal government does not grant tax holidays, but local governments sometimes do. If you live in a state that does, you may be exempt from paying sales tax for a period of time.

For a short time, typically a week or weekend, a state or local government may temporarily forego collecting sales tax on a subset of goods. These celebrations are already traditional in many states, and they frequently have a seasonal theme, such as the end of summer and the beginning of school or hurricane season.

There were state tax holidays in 2020 in 17 states and Puerto Rico. Another 5 states and Puerto Rico declared state tax holidays for 2021.

Alaska, Delaware, Montana, New Hampshire, and Oregon are among the states that do not impose any kind of sales tax on their residents. 

If you live in a state adjacent to one that does not have a sales tax, you can treat yourself to a tax-free holiday whenever you like by making your back-to-school, major gift-giving holiday, or large-ticket item purchases across state lines.

3. It’s Hard to Fix Our Tax System

Taxes in the United States are a hot topic of conversation among politicians and pundits, who have strong opinions on how taxpayer monies should be allocated. It’s important to remember that decisions aren’t made in a vacuum, even while it’s always useful to consider novel approaches to enhancing our tax laws.

Legislative measures that appear beneficial at first glance often have unexpected consequences, while others that appear impossible or expensive actually have a chance of succeeding with the right kind of implementation.

The FairTax, a guaranteed minimum income, and access to healthcare for all are a few such proposals.

A fair tax

It is the belief of FairTax backers that a 23 percent federal sales tax should replace income and payroll taxes since doing so will boost individual income, jumpstart the economy, reduce the complexity of tax administration, and make it easier to budget for government spending. 

Despite the elimination of federal income and payroll taxes, state income taxes would remain.

However, a national sales tax was examined by President George W. Bush’s tax reform team during his administration. However, it abandoned the plan when it became clear that interest rates far higher than 23% would be required for the scheme to be viable.

Automatic Basic Income

According to proponents of universal basic income (UBI), all legal adults in the country would receive a regular cash payment from the government. Advocates for UBI say it would help those living in poverty and would take the place of current social programs like welfare and Social Security as well as food stamps.

A UBI of $10,000 per year for the more than 300 million Americans in existence today would cost the federal government over $3 trillion per year, or over 100% of all tax income collected by the federal government.

Some lawmakers and officials support a guaranteed minimum income to reduce expenses and provide aid to those with lower incomes. While it’s conceptually similar to universal basic income (UBI), this scheme would only benefit those with the lowest incomes.

Universal Health Care

Access to medical treatment is a basic human right, and in a universal health care system, that right is upheld for every citizen. Both universal coverage and premium subsidies for the uninsured are on the table as potential organizational frameworks for health care reform.

Medicare for All, a national health insurance plan for all Americans that would replace private health insurance firms, is one such universal health care system that has been in the news recently. What method would the federal government use to fund this? How? Why by paying taxes?

No current Medicare for All proposal includes a thorough tax plan, however, an analysis by the Committee for a Responsible Federal Budget argues that any tax increases resulting from implementing Medicare for all would be mitigated by:

  • Eliminating the premiums individuals currently pay for private health insurance
  • Eliminating all out-of-pocket health care costs paid by individuals and families
  • Higher salaries for workers because their employers would no longer pay health insurance premiums

4. There is a Very Low Chance That the IRS Will Audit You

Many taxpayers experience anxiety at the mere mention of the term “audit,” notwithstanding the exceedingly low likelihood that they will really be audited. Among all tax returns submitted between 2010 and 2018, the Internal Revenue Service only audited 0.60 percent of individual returns and 0.97 percent of business filings.

Taxes on personal and corporate income account for more than half of all government revenue, per the Tax Policy Center. It would make sense, then, for the IRS to prioritize collecting its due from all taxpayers.

Unfortunately, the IRS has fewer resources to devote to monitoring as a result of decreases in budget and manpower over the past decade.

When the IRS does go after tax fraudsters, they go after the big fish, meaning high-income earners. The IRS claims that the audit rates for taxpayers with incomes of $10 million or more are far higher than audit rates for individuals in other income brackets.

This, however, does not give you carte blanche to lie on your tax return. Although they use complex computer algorithms, the IRS is still auditing hundreds of thousands of tax returns annually. 

Your chances of being selected for an audit by the IRS increase significantly if you use any of the frequent tax audit triggers or claim any tax benefits for which you do not qualify.

Independent contractors and those who own small businesses must exercise extra caution. Earlier this year, the IRS revealed that it will prioritize audits of small firms till 2021.

5. Be Patient If You Need IRS Assistance

It’s not easy to navigate tax-related issues including tax brackets, tax returns, tax debts, and IRS notices. However, the IRS employs professionals with the mission of assisting taxpayers. There just don’t seem to be enough of them.

It was reported to Congress that the IRS received over 100 million calls on its toll-free lines during the 2020 fiscal year by the Taxpayer Advocate Service. However, just 24 million calls were answered by IRS employees, and taxpayers waited for an average of 18 minutes on hold before getting help.

In-person assistance is an option, but it might be challenging to find qualified people to help you. Recent years have seen the closure of many IRS Taxpayer Assistance Centers, with the surviving centers now being appointment-only.

This has resulted in a decrease from 4.4 million taxpayers in 2016 to 2.3 million taxpayers in 2019 who are serviced in person by the IRS.

Check out the IRS’s online self-service options first if you can, rather than picking up the phone to call them. Checking your refund status, paying your tax bill, checking your account balance, applying for a payment plan for your tax liability, downloading tax forms, and ordering a tax transcript are all things you may do online instead of calling an agent.

However, it’s important to remember that IRS employees aren’t able to answer questions about your general tax situation or personal finances, such as which expenses are deductible, how much you should put into an IRA or other retirement account, which donations are tax-deductible, or whether or not you qualify for a dependent exemption.

Consult a tax preparer or tax professional, such as a certified public accountant (CPA), for assistance with these issues. Calling the IRS Practitioner Priority Service line, which is staffed by IRS employees specially trained to assist tax professionals in resolving their clients’ tax concerns, can also be helpful.

Even seasoned accountants, however, recognize the importance of patience in the modern world. Long wait times are to be expected, especially during the busiest months of February through April, when tax season is in full swing and the coronavirus pandemic is at its peak. 

Your tax advisor will also need you to sign Form 2848, which gives them authority to represent you in communications with the IRS.

6. The Tax Rate You Pay Is Not Based on All of Your Taxable Income

Anyone who has studied taxation in the United States would know that the federal income tax has seven different brackets, with rates ranging from 10% to 37%. If you believe that everyone in the 32% tax bracket pays taxes on 100% of their income, you’d be wrong. Contrary to popular belief, however.

Each income level is subject to a different marginal tax rate, which is represented by the tax brackets. 

Take the following example based on the tax brackets for individuals in 2021:

Tax RateSingle
10%Up to $9,950
12%$9,951 – $40,525
22%$40,526 – $86,375
24%$86,376 – $164,925
32%$164,926 – $209,425
35%$209,426 – $523,600
37%$523,601 and up

So, in 2021, a single person with an income of $80,000 will pay 22% in taxes.

Here is how you would figure out your tax bill:

  • 10% of the first $9,950 of income = $995
  • 12% of the next $30,575 of income = $3,669
  • 22% of the last $39,475 of income = $8,685

Your estimated tax liability for 2021 is $13,349. This equates to an effective tax rate of about 17%. Understanding the tax implications of earning additional money is simplified when you are aware of your marginal tax rate.

Imagine, for the sake of argument, that you are considering investing $25,000 of your own money in a property that will bring in an additional $25,000 annually, putting you in the 24% tax bracket.

In the end, you may decide that the investment isn’t worth the hassle of taking care of the property after paying all the necessary taxes.

7. The U.S. Comparatively to other developed nations, tax rates are quite low for taxpayers.

When compared to other developed countries, the United States actually has one of the lowest effective tax rates.

Tax receipts in the United States are at a record high, at 24.5% of GDP in 2020, according to the Organization for Economic Co-operation and Development (OECD) (GDP). That’s far lower than the OECD average of 33.8%, where 35 countries are represented.

Tax receipts as a share of GDP are highest in the following five countries, the study finds:

  • Denmark: 46.3%
  • France: 45.4%
  • Belgium: 42.9%
  • Sweden: 42.9%
  • Italy: 42.4%

The percentage of GDP that is raised by taxes is the lowest in only five OECD countries:

  • Turkey: 23.1%
  • Ireland: 22.7%
  • Chile: 20.7%
  • Columbia: 19.7%
  • Mexico: 16.5%

The money a country brings in is, of course, a major factor in that study. Where do we stand on tax rates for individuals?

Even there, the United States ranks towards the bottom. The Tax Foundation analyzed the highest marginal effective tax rates in the United States and 40 European countries in 2019. U.S. citizens pay about 47% of their income in taxes, contributions, payroll, and consumption, putting the country in the bottom third of the rankings.

Some of the countries with the highest taxes were:

  • Sweden: 76%
  • Slovenia: 73%
  • Belgium: 73%
  • Portugal: 72%
  • Finland: 71%

For this comparison, the countries with the lowest tax rates were:

  • Slovakia: 45%
  • Lithuania: 44%
  • New Zealand: 44%
  • Mexico: 42%
  • Bulgaria: 29%

Bottom Line

For as long as there have been lawmakers and taxpayers, the issue of taxation and its distribution has been contentious.

The two major parties generally agree on the issues of the excessive national debt, the negative effects of globalization on American workers and industry, and the pervasiveness of income inequality.

They are not on the same page about how to resolve these difficulties. Although there is no silver bullet, we can at least make progress by acknowledging the problems and evaluating the fallout from proposed changes to the tax law.

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