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Young adult woman doing taxes on her laptop in a coffee shop, reading blog: What are taxes?

Apr 27, 2023

What are taxes? Who pays them and what are they used for?

The TL;DR: Taxes are mandatory payments collected by the government (local, state, or federal) to fund government services. 

Although the definition of taxes is simple, we know there’s much more to cover. So whether you’re filing your first tax return or simply wondering, ‘How do taxes work?’, we’re here to answer your questions and break down the tax terms you need to know.

What are taxes used for?

Definition of taxes, check. Now, what do taxes pay for? 

Tax money funds many of the public services you see daily in your community. These services include:

  • Maintaining roads and bridges

  • Law enforcement

  • Fire departments

  • The justice system

  • Public education

  • Airports

  • Public transportation

  • Government workers (including teachers, lawmakers, and other professionals that work for local, state, or federal governments)

Who pays taxes?

The short answer is – everyone. When we talk about taxes, we usually mean income taxes (more on that below). As of 2022, any single person (under the age of 65) who makes a gross income above $12,950 must pay income tax

However, even if you don’t pay income tax, you’ve probably paid another type of tax – sales tax! Sales tax is automatically added to the price of most items and services. It contributes to the same public services as income taxes. 

Let’s look at sales tax in action. Imagine finding the perfect jeans at your favorite clothing store. They cost $25.00. When you check out, you’ll need to pay $26.25 because of sales tax. 

5 different types of taxes

Although the taxes definition includes any mandatory payments made to the government, there are five main types of taxes to know about. Let’s dig in. 

Income tax

As its name suggests, income tax is the tax you pay on your income. You pay a certain percentage of your income to state and federal governments to fund the public services we mentioned above. The percentage you pay depends on how much money you make, what state you live in, and what state you work in. 

Typically, your employer withholds income tax from each paycheck and sends it to the government (so you don’t have to submit payments manually). However, business owners, sole proprietors, and independent contractors submit their own quarterly estimated taxes.

Everyone that pays income tax also submits (drumroll, please…) an annual tax return. Tax returns are a collection of forms you submit to the government at the beginning of the year to report your income and the taxes you paid during the previous year. You’ll also report any money you made from investments

The government compares your tax return with its records to ensure you paid the correct amount of tax money. If you paid the government too much, you’ll get a tax refund (which means the government pays you back). If you underpaid, you’ll owe additional money to make up for the difference. 

Greenlight tip: Use your tax refund to start investing. With the Greenlight app, kids and teens can learn to invest, with over 4,000 stocks and ETFs to choose from. 

Payroll tax

Payroll tax is a type of tax that both employers and employees pay. Just like income tax, payroll tax is calculated as a percentage of your income. It’s also withheld from each paycheck. However, payroll tax (unlike income tax) contributes to Social Security and Medicare. 

Sales tax

Sales tax is the tax placed on most goods and services for sale. This includes clothing, hotel stays, and pretty much anything you buy online or at a store. 

The amount of sales tax you pay depends on the city and state. California has the highest sales tax rate of any state (7.25%). Colorado, on the other hand, has one of the lowest rates (2.9%). Alaska, New Hampshire, Montana, Delaware, and Oregon don’t impose sales tax at all. 

Property tax

Property owners pay taxes on their property each year (typically in two installments).

“Properties” include owned houses, condominiums, business properties, or farm properties (although farmland property tax is often lower than other property taxes). 

So, how does property tax work? Property tax is calculated as a percentage of the value of your property. The amount you pay depends on the county, city, and state you live in. For example, if your home is worth $200,000 and the property tax rate where you live is 0.5%, you will pay $1,000 in property tax. 

Estate tax

When someone dies, estate tax is the tax collected on their assets. However, federal estate taxes are only imposed if the deceased person has over $12.95 million in assets. Assets may include cash, real estate, insurance, securities, trusts, and other personal or business assets. The key to estate taxes? They’re taken directly from the estate’s assets (not family members). 

You may be thinking, “But what about inheritance tax?” Inheritance tax, unlike estate tax, is paid by the beneficiary. Only six states impose inheritance tax (including Pennsylvania, New Jersey, and Maryland).

Taxes? Check. What else is there to learn?

Understanding basic tax terminology — and how taxes work in the first place — is an important part of financial literacy. After all, everyone pays taxes. 

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