Different types and amounts of taxes are levied based on income sources, amount of income, and spending habits. For example, a sales tax is considered regressive as it takes a larger percentage of income from low-income earners.

Different types of income are taxed differently to promote fairness, incentivize certain behaviors, and support various government services. For instance, long-term capital gains are taxed at a lower rate to encourage saving and investment.

• Example: James, who earns $50,000 a year, pays a higher percentage of his income on sales taxes compared to Olivia, who earns $150,000, when they both buy the same $1,000 television.
  
  

Earned Income:

Earned income, such as wages or salaries, is subject to federal income tax rates that range from 10% to 37%, depending on the tax bracket the individual falls into. 

Federal income taxes fund national programs and services, while state income taxes fund state-level programs.

Payroll taxes, such as Social Security and Medicare taxes, fund their respective programs at the federal level.

• Alice earns a salary of $80,000 and falls into the 22% federal income tax bracket. If Alice receives $2,000 in qualified dividends and a long-term capital gain of $3,000, these would be taxed at a maximum rate of 15%, assuming she is not in the highest income bracket. Her salary would be taxed at the various rates leading up to 22%, but her investment income would be taxed less, enhancing the overall efficiency of her tax strategy.
• Bob, an independent contractor, earns $50,000, which he reports on Schedule C. His income is subject to self-employment tax, which includes both the employee and employer portions of Social Security and Medicare taxes, as well as income tax. Bob might choose to contribute to a SEP IRA, which could reduce his taxable income and provide retirement savings.

Unearned Income:

Income derived from investments, such as dividends, interest, or capital gains.

Interest Income:

Interest income, typically from savings accounts or investments like bonds, is taxed as ordinary income at the same rates as earned income.

Capital Gains:

Capital gains are the profits from the sale of assets like stocks or real estate. Short-term capital gains (for assets held less than a year) are taxed as ordinary income, while long-term capital gains have lower tax rates, generally 0%, 15%, or 20%, depending on your income level.

Tax Rate Comparison:

Unearned income like capital gains can have different tax rates compared to earned income, often leading to a lower tax liability for investments held long-term.

Sales Tax:

Sales tax applies to most goods and some services. Essential items like groceries and prescription medications are often exempt to reduce the tax burden on necessities.

Sales taxes are usually imposed at the state and local levels and fund state and local government operations.

Property Taxes:

Property taxes are typically collected by local governments and fund local services like public schools and emergency services.

Earning income vs. Capital Gains

Earned income is usually taxed at a marginal rate, meaning that as income increases, the rate of taxation also increases through tax brackets. This progressive tax system is designed to ensure that those who have higher incomes contribute a larger percentage to the tax base.

Capital gains, on the other hand, are typically taxed at a lower rate to encourage investment in businesses and the stock market. This preferential rate applies to long-term investments held for more than one year, reflecting the belief that long-term investment contributes to economic growth.

Dividends from stocks can be qualified or non-qualified, with qualified dividends benefiting from lower tax rates similar to long-term capital gains.

• 1. Earned Income Scenario:
  • Person: Jane, a software developer
  • Annual Salary: $85,000
  • Federal Income Tax Rate: 24% for her tax bracket
  • State Tax Rate: 5% (in her state)
  • FICA Taxes: 7.65% (combined Social Security and Medicare)
  • Scenario: Jane’s take-home pay is affected by these various taxes, which are automatically withheld from her paycheck. If she contributes to a 401(k) or traditional IRA, she might lower her taxable income and hence pay less in income taxes.

• 2. Capital Gains Scenario:
  • Person: Alex, an investor
  • Stock Sale Gain: $20,000 (held for more than a year)
  • Federal Capital Gains Tax Rate: 15% (for his income level)
  • State Tax Rate: None (in his state)
  • Scenario: Alex sells shares he has held for over a year. His profit from the sale, known as a long-term capital gain, is taxed at 15% instead of his regular income tax rate, which would be higher.