Income Tax 101: What’s Taxable?
Most people are familiar with income tax because each year they are required to file a tax return. But that’s only a sliver of what they actually pay. Some taxes are automatically deducted from your paychecks or when you buy something from the store, while others only apply under special circumstances. Plus, you might not even be taxed on all of your income, and the income that is taxable might vary in rate.
As you prepare your tax returns, it’s helpful to have a good understanding of how you are being taxed.
Income Tax Vs. Other Taxes
In addition to the federal income taxes you pay, many states charge an extra state income tax. Some municipalities and school districts will also charge a separate income tax. Here are some of the ways you might be taxed:
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Payroll taxes
Also known as “employment tax,” payroll taxes are automatically pulled from your paychecks for Social Security and Medicare. For the 2018 work year, employees were required to pay 6.2% of their first $128,400 earned income to Social Security and 1.45% to Medicare. Employers are required to match both of these amounts.
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Sales taxes
Sales taxes are paid as a percentage of when you purchase goods or services. It’s important to know that they are only collected on the state and/or local level, and each state has their own rates—if any at all. The states with no sales tax generally levy a combined local and state tax upwards of 10%. Sales taxes are considered regressive tax because lower earners end up spending a larger portion of their income on them compared to higher earners.
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Excise Taxes
These are similar to sales taxes in that they are charged when you make a purchase, however, they only apply to certain goods or services. These purchases often fall under the description of “sin products” and include goods like alcohol, cigarettes, and gasoline. Gasoline is the most commonly paid excise tax and is collected by the federal government. Excise taxes are often applied on top of current sales taxes.
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Property taxes
Property taxes are collected at the state and/or local levels and most often occur on real estate or other larger purchases like vehicles. They tend to fluctuate with the market value and support local or county services like garbage, road maintenance, and fire protection.
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Estate taxes
These are the taxes that are collected off the assets you leave for a beneficiary after your death. It includes cash, securities, insurance, real estate, and business interests. Estate taxes don’t apply to everyone. For 2018, estates worth more than $11.18 million are subject to tax, and estates worth more than that are only taxes on the value that exceeds this limit. Depending on the state you live in, you might also be subject to estate tax on the state level.
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Gift taxes
Gift taxes are similar to estate taxes but only apply to gifts you give to another person while you are still alive. This only applies to high-value gifts that reach or surpass a certain threshold. For 2018, the annual gift tax exclusion limit capped at $15,000 per recipient. Gift taxes only applies if your gift exceeds the annual exclusion.
Taxable vs. Non-Taxable Income
For the most part, any income you receive for any source is subject to taxation. This includes wages, salaries, commissions, interest, stock options and dividends, unemployment compensation, rental income, and alimony. Income tax also includes “fringe benefits” like company-paid gym memberships, company vehicles and holiday cash gifts from your employer. And it includes other forms of income such as canceled or forgiven debts or loans, money from offshore accounts, property you obtained through barter, and payments from employer-paid disability, sickness and injury plans.
There are, however, a few exemptions from federal income tax. Being aware of these exceptions could help to lower your tax bill. Here are the most common forms of non-taxable income:
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Inheritances, gifts, and bequests
Most inheritances and gifts you receive are not subject to taxation. That said, you will owe taxes on estates that exceed the annual exclusion figure (see above).
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Life insurance payouts
Any money you receive on a life insurance policy after someone dies is not taxable income. If you cash out the entire policy, however, that money is usually taxed.
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Qualified scholarship money
While money from a qualified scholarship is not subject to taxation, any of that money that goes towards room and board is.
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Other non-taxable income
Other types of income might include municipal bond interest, most health care benefits, child-support payments, welfare payments and cash rebates on purchases. You can take advantage of all these exemption and deductions.
Closing Thoughts:
Knowing what taxes to expect and the areas you can write-off or save on taxes will help make filing your returns easier. Talk to your fiduciary financial advisor or seek out a tax specialist to walk you through this process. Get someone to help you optimize your returns and live life with purpose.