Federal taxes vs. state taxes vs. local taxes
When taxes are discussed, the most prominent tax type that people talk about is the federal income tax. But this is just one of the taxes that U.S. residents pay on a regular basis. Most states in the country have their own income taxes, and then there are local income taxes in some jurisdictions. Thus, when we want to understand the taxation system, we need to consider all of the three tax types – federal taxes, state taxes, and local taxes. If you are looking for the best tax relief options, it is imperative that you understand the distinction between the three. In this article, we will show you what the differences between them are.
What are taxes?
To start with, we first need to understand why we even pay taxes in the first place. Taxes are mandatory contribution that is levied on corporations or individuals by their governing body. They serve to finance most public services and activities such as roads, schools, social security, medication, etc. In the U.S., the entity that is ensuring that everyone pays their federal taxes in due time is the Internal Revenue Service (IRS). However, aside from the federal taxes, local and state governments can also levy their own taxes.
Almost every tax is applied as a percentage of earned income or a completed transaction. Every state creates its own percentage, meaning that it can be very different from state to state. Some states, for example, do not levy any income tax whatsoever.
Different types of taxes
Before we get into the federal taxes vs. state taxes vs local taxes distinction, it is very important to understand different tax types. The most common tax types are:
- Income taxes
- Payroll taxes
- Corporate taxes
- Sales taxes
- Property taxes
- Estate taxes
These taxes are levied on taxpayers as a percentage of generated income. They are usually paid to either the federal government or the state, or both.
The U.S. utilizes a progressive income tax system, meaning that individuals that earn more pay more in tax. There are numerous factors that affect tax rates, such as filing status, source of income, etc. For example, the status of a person’s tax files can be highly impactful on how much taxes they need to pay. That is why it is extremely important to always be current on your tax returns, as well as to file them properly.
Another type of income tax is capital gains tax. It is particularly relevant to investors, as it is both levied and enforced at the federal level. Capital gains tax taxes the amount of profit when selling an asset that increased in value since the time of purchase. The rate of taxation on capital gains mostly depends on the duration of time for which the asset was in the individual’s possession. Thus, capital gains on assets sold after one year or less are taxed at regular income tax rates. But long-term capital gains are taxed at a lower tax rate. This serves to encourage capital investment.
Payroll taxes form a percentage that is automatically withheld from an employee’s paycheck and are paid by the employer. These taxes are primarily utilized to pay for Social Security programs, as well as Medicare.
Payroll taxes have two components: The employee portion and the employer portion. Basically, your employer will pay the payroll tax “twice”. What is important to note here is that payroll taxes are not the same as income taxes. For example, if you are a self-employed individual, you still need to pay both income and payroll taxes. You file them under self-employment taxes but it is basically the same thing. The reasoning behind this is that payroll taxes are specifically funding Medicare and Social Security programs.
Corporate taxes take a “cut” from corporate profits. Every state has its own percentage on how much corporations need to pay in corporate tax. The government utilizes the money from these taxes to fund a variety of federal programs.
The government uses the following system to calculate a company’s taxable income:
- Sales revenue minus the cost of goods sold equals gross profit.
- Gross profit minus the operating expenses (general and administrative, marketing, selling, R&D, etc.) equals earnings before interest and taxes (EBIT).
- EBIT minus interest expense equals taxable income.
Whenever an individual purchases or sells something, the sales tax “kicks in”. The specifics of sales taxes vary greatly by jurisdiction. In some jurisdictions, there is no sales tax whatsoever. But it can be quite high in others.
Sales taxes are charged when a person pays for their goods or services. However, the business collects the sales tax and sends it to the government. Every state has the right to create and manage its own sales taxes, and even cities can have their own sales tax rates. All taxes must abide by the taxing rules of the state, of course.
For example, the highest average state/local tax rates in 2021 were in Tennessee, where they were 9.55%. And five states (Delaware, Alaska, New Hampshire, Oregon, Montana) chose not to include any sales taxes whatsoever. In Alaska, though, some municipalities were allowed to charge local sales taxes.
If you own any property, expect that you will need to pay tax for simply owning it. These taxes are based on the value of your full assets and they vary greatly by tax jurisdiction.
For example, the state that had the highest property tax collections per capita in 2018 was New Jersey, at $3,378 collected from each qualified taxpayer. The lowest was in Alabama, at only $598 per capita. As you can see, that is quite a large difference!
Whenever a tax is applied on imported goods, it is called a tariff. These taxes are imposed to protect domestic businesses, as they provide additional importing costs.
The two main tariff types are Fixed Fee tariffs and Ad Valorem tariffs. The former is levied by the government as a fixed cost that is based on the type of the item in question, while the latter is a percentage of the item’s full value, similar to real estate tax.
The estate taxes are paid once the original estate holder passes away. The total estate value needs to exceed a certain threshold first, and the tax rate is applied to the Fair Market Value (FMV) of the estate. Note that spouses are exempt from any estate taxes.
Estate tax rates follow a progressive marginal rate. The rate can be as low as 18% and can go up to 40%. But the latter is only levied on any estate portions that exceed the exclusion limit by more than $1 million. There is quite a difference between federal and state taxes in this case, as states may have lower exclusion limits.
Understanding Federal taxes vs. State taxes vs. Local taxes
Most of the time, taxpayers will be dealing with federal income taxes. This is a tax type that garners the most attention, after all. However, federal income taxes are only a portion of the money that U.S. taxpayers pay. Most states have their own income taxes, and there are thousands of jurisdictions that have their own local income taxes.
All these tax jurisdictions utilize a wide variety of tax systems. For example, some states have a flat income tax, some have none at all. However, states can only tax certain income types and are free to maintain their own income deductions and have unique provisions.
What this means is that an average taxpayer needs to understand how various tax levels work in their specific community. This information can be of crucial importance for lowering the overall tax bill.
Taxes that are levied by the federal government utilize a graduated income tax system, otherwise known as the progressive tax system. The current tax brackets range from 10% to 37%, meaning that different tax rates can be applied to different income portions.
To illustrate the point, imagine that a person has an annual income of $50,000. They will need to pay 10% in income tax on the first $9,950 earnings, while they pay 12% for income that is more than $9,950 and up to $40,525. Income that goes over that threshold is taxed at a 22% tax rate.
This means that even if the tax rate for income over $40,525 is 22%, the taxpayer is not taxed the full 22% of the entire sum. Furthermore, the tax brackets continue to increase along the same lines until they reach the maximum of 37%. To reach this number, a person needs to have an income of $523,600. After that point, any additional income will be taxed at the 37% tax rate.
The federal government also offers a variety of deductions, meaning that most people will pay taxes for less income than they actually earn. An example of this is the 2021’s standard deduction of $12,550 for single taxpayers, doubled if married couples are doing joint filing.
Taxes are calculated differently at the state level, but most states use a similar taxation system. Thirty-two states have a graduated income tax system, whereas nine states use a flat income tax system, and seven states have no income tax at all.
Some states may also base their taxes on individuals’ federal adjusted gross income. Other states make some adjustments by offering unique tax credits and deductions. For example, California offers a deduction of unreimbursed employee expenses, something that was eliminated in 2017’s Tax Cuts and Jobs Act.
Other states may exclude certain income types. Prime examples of these exclusions are Social Security and government pensions. In some states, these are excluded from all tax calculations. New Hampshire, for example, only uses a flax tax rate for income that comes from dividends, interest, and a few other sources.
States that have flat tax systems usually have a tax rate between 3% and 5%. States with marginal tax rates are free to create their own taxation system. For example, North Dakota has five tax brackets, starting at 1.1% and peaking at 2.9%. On the other side, California has as many as 10 tax brackets, starting with 1% for income up to $8,932, culminating at a 13.3% tax rate for income over $1 million. Of course, these numbers apply to single filers.
Local income taxes can be levied by municipalities such as counties, cities, school districts, etc. These taxes are “few and far between”, however, and most municipalities do not use them. Local income taxes are mostly found in Midwestern and Great Lakes region states, with the majority of them being in Pennsylvania and Ohio. The tax rate usually doesn’t go over 3% and is oftentimes as low as 1%.
Most of the cities that use local taxes will tax every income you get, bar Social Security income. Furthermore, cities may also impose both resident and non-resident taxes. Residents will pay local taxes on all income, regardless of where they earn it, while nonresidents only pay local income taxes on the money they earn in that municipality. However, residents that work in a different municipality that also charges an income tax can apply for tax credits.
Key differences between federal taxes, state taxes, and local taxes
The main difference that we can observe in tax rates based on their jurisdictions are:
- Federal tax rates are usually higher than state or local tax rates
- States and municipalities can introduce a variety of deductions and credits
Also, while some states have their own definition of AGI (Adjusted Gross Income), most of them utilize a federal system of tax calculation. Due to this fact, taxpayers can get some of the federal tax deductions when filing their state taxes. Most notably, health savings accounts and contributions to qualified retirement funds, as both of these are deducted from taxpayers’ income when determining their federal AGI.
What most states do is make some adjustments to the federal AGI by offering deductions, credits, or even add-backs. These items will be deducted from federal returns but they will be taxable by the state itself. Even though you might be able to deduct some local and state taxes on your federal returns, some states may require you to add them back for the purposes of state income tax calculation.
Taxes form an intricate web of systems, regulations, credits, and deductions. It is so complicated that you may want to consider hiring a professional tax relief company to help you with your federal taxes returns. If you wish to know what the best tax relief companies are, or anything else about taxes and all their intricacies, explore Consumer Opinion Guide. We are there to provide you with all the information you might require to make the best financial decisions that you can!