The US taxation system
Navigating the US tax system can be complex, often requiring professional advice for proper understanding. We've all seen scenes in movies with people scratching their heads over piles of paper as they struggle to do their taxes. The truth is, taxes are complicated in the US compared to many other countries, partly because of a dual system where taxes are levied at both federal and state levels, with potential additional obligations for city and district taxes depending on your location. Foreign nationals employed in the US are also subject to taxation, and it can take a while to get your head around all of your obligations.
This article provides essential information on the complexities of the US taxation system, aiming to assist those who are unfamiliar with its nuances.
Tax system in the US
The government agency that manages and regulates taxes in the country is the Internal Revenue Service — or IRS. When it comes to state taxes, they are managed individually by each state.
There are several types of taxes in the US:
- Federal income tax is a progressive federal tax imposed on income;
- Personal income tax is a progressive/fixed state tax imposed on income;
- Capital Gains Tax is a federal tax on income from stock and bond-related transactions;
- Payroll tax is taken from an employee's salary and is usually withheld directly by the employer. This is used as a contribution to the employee's Social Security and Medicare — and is paid by both the employer and the employee in equal parts. Currently, the tax rate for Social Security stands at 6.2% for the employer and 6.2% for the employee (12.4% in total); the current tax rate for Medicare is 1.45% for the employer and 1.45% for the employee (2.9% in total);
- Property tax is primarily imposed on real estate: land, buildings, industrial space, etc. However, some states also impose it on valuables: cars, technical equipment, furniture, etc. Tax rates vary by state and range from 0.27% to 2.35% of the total appraised value of the property;
- Sales tax is a state tax on goods and services that is added to the cost of retail items. Statewide sales tax ranges from 2.9% (Colorado) to 7.25% (California). Cities can then add additional sales tax at a local level, bringing the total tax to 11% in some cases. These taxes are automatically added to items and paid at the time of purchase.
Alaska, Delaware, Montana, New Hampshire, and Oregon currently do not have a sales tax. These can be referred to as the NOMAD states (“N” for New Hampshire, “O” for Oregon, etc.).
Important: this is something to be mindful of in a number of states in the US when doing your shopping. The price you see on the price tag may not be the full price of the product, and you will need to pay more at the counter. Check your receipt for “tax” to see how much it was on a particular item.
What is the income tax rate in the US?
In order to pay your annual income tax, you need to identify your taxable income. For this, you will need to subtract standard or alternative deductions from your total income; a deduction is money that is not subject to government tax. A standard deduction is a fixed amount that is reviewed and adjusted every year. An alternative deduction is meant to identify all of your expenses that are not subject to tax (these typically include medical expenses, state and local income tax, contributions to charity, and more).
Note that the income tax in the US is calculated at a progressive rate, and tax brackets are adjusted annually based on the rate of inflation.
In 2023, tax rates varied between 10% and 37%, depending on your income. These rates are applied differently to single filers, married individuals filing joint returns, and heads of households:
- 10% tax rate: Applies to income from $0 to $11,600 for single filers, $0 to $23,200 for married individuals filing joint returns, and $0 to $16,550 for heads of households;
- 12% tax rate: Applies to income from $11,600 to $47,150 for single filers, $23,200 to $94,300 for married individuals filing joint returns, and $16,550 to $63,100 for heads of households;
- 22% tax rate: Applies to income from $47,150 to $100,525 for single filers, $94,300 to $201,050 for married individuals filing joint returns, and $63,100 to $100,500 for heads of households;
- 24% tax rate: Applies to income from $100,525 to $191,950 for single filers, $201,050 to $383,900 for married individuals filing joint returns, and $100,500 to $191,950 for heads of households;
- 32% tax rate: Applies to income from $191,950 to $243,725 for single filers, $383,900 to $487,450 for married individuals filing joint returns, and $191,950 to $243,700 for heads of households;
- 35% tax rate: Applies to income from $243,725 to $609,350 for single filers, $487,450 to $731,200 for married individuals filing joint returns, and $243,700 to $609,350 for heads of households;
- 37% tax rate: Applies to income of $609,350 or more for single filers, $731,200 or more for married individuals filing joint returns, and $609,350 or more for heads of households.
This breakdown is based on the tax brackets provided for the 2023 tax year and is subject to change in subsequent tax years.
In order to file tax returns in the US, you will need a Social Security Number or a Taxpayer Identification Number. Your taxes will also depend on how long you've been in the country and your fiscal status (if you are a resident, non-resident, dual-status taxpayer, etc.).
The fiscal year in the United States is typically the same as the calendar year. However, if you want to, you can choose a different period. If you do, keep in mind that the deadline set by the IRS will remain to be 15 April. If, for some reason, you are unable to file your tax returns in time, you can apply for an extension — it will be automatically set to 15 October.
Paying local and state taxes in the US
In addition to paying federal taxes, most residents, as well as non-residents, will also be subject to paying state taxes. The tax rate and other specifics depend on the state you reside in.
In addition to federal tax, most residents and non-residents of the US need to pay taxes to the state they reside in. The contributions depend on the state you live in, how long you are staying there, as well as your income.
A state income tax is a tax on income earned in that state. It is similar to a federal income tax, but state income tax funds assert budgets rather than the federal government. State income tax is lower than federal income tax and can range from 0 to 13.3%.
Some states have a progressive tax, while others have a flat tax. Nine states do not levy a state income tax at all. These are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming.
What is Alternative Minimum Tax in the US?
If you earn what is considered to be a high income in the United States, you may also be subject to
Alternative Minimum Tax (AMT). You are generally required to pay AMT if your adjusted gross income is over the established threshold known as exemption. This threshold is adjusted every year based on the current inflation rate. For the 2024 tax year, it's $85,700 for individuals and $133,300 for married couples filing jointly.
If your income is below the threshold, you won't have to pay AMT. If it is higher, you will either need to pay standard income tax or AMT (depending on which is higher).
Taxes for the self-employed in the US
In addition to paying the income tax, self-employed people are also subject to Self-Employed (SE) taxes.
SE taxes work for the self-employed in the same ways as payroll taxes work for employed workers: they are meant to be contributions to Social Security and Medicare. In most cases, 92.35% of your net earnings from self-employment is subject to SE taxes. The current rate for SE tax is 15.3%. The rate consists of two parts: 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
How to determine your tax status in the US?
Foreign nationals living and working in the United States are subject to one of two different tax systems based on residency status. This tax status depends on whether you are classified as a resident alien or non-resident alien.
Your status is considered as a resident alien by the IRS if:
- You hold a Green Card;
- You have lived in the United States for more than 183 days;
- You have lived in the United States for more than 30 days during the last calendar year and at least 183 days during the current year and the previous 2 years.
If you do not meet one of these criteria, you fall into the non-resident alien tax classification.
Resident aliens are liable for taxes on income from any source, regardless of their origin country.
Non-resident aliens are taxed only on income from US sources, such as a US salary or investments. Tax rates are calculated based on income and whether you are single, married, or filing as the head of household.
Resident aliens and non-resident aliens making more than USD 4000 per year are required to file a tax return at the end of the fiscal year.
Exceptions to residency status in the US
There are a number of exceptions that need to be considered when determining your tax status in the US. These exceptions exempt some legal residents in the US from having to report taxable income.
Here are some of these exceptions:
- Commuting from Canada to Mexico;
- Having a tax home elsewhere;
- Belonging to a specific resident category. Aliens who must reside in the United States temporarily for specific reasons can claim an exemption for the days spent in the country. This typically applies to teachers and students, trainees, professional athletes, and people who have diplomatic or consular status and are working for a foreign government or an international organization;
- Qualifying for a medical exception;
- Tax treaty being in place.
Income tax for non-residents in the US
As mentioned above, non-residents in the US are only required to pay income tax on what they earn in the United States or from a US source. They do not need to pay tax on income they earn from abroad.
For instance, if you are a citizen of Spain who has a business in Spain and a business in the US, you will only be taxed on your earnings from your US company. The income from your Spanish business won't be taxed.
Investment income that is realized in the US but is not from a US source is typically taxed at the rate of 30% (unless otherwise specified).
Note that as a non-resident alien in the United States, you need to keep detailed records to show all your income sources. The Internal Revenue Service (IRS) will then see which income is tax-exempt and which isn't.
Income tax for resident aliens in the US
Unlike non-resident aliens in the US, most US residents are taxed on all forms of income — both local and foreign, including foreign payment pensions.
Resident aliens may be able to claim foreign-earned income exclusion and/or foreign tax credit if they qualify.
Additionally, resident aliens who are employed by a foreign government in the US may be entitled to an exemption on their earnings if the government that employs them has a reciprocal tax treaty with the US.
Dual taxation in the US
Aliens who receive their Green Cards during the tax year may find themselves in a dual taxation situation. This happens because they were classified as non-residents before receiving their Green Cards — and as residents after. Their status change occurred on the very day they received their Green Card.
In this case, you will need to file a statement that will break down all income you have received, both as a resident and as a non-resident.
Tax treaties with other countries
The United States has established tax treaties with numerous countries around the world to address issues related to double taxation and tax evasion. Some of the countries with tax treaties with the US include, but are not limited to Canada, United Kingdom, New Zealand, Germany, Japan, Australia, France, India, China, South Korea, and Mexico.
These treaties serve various purposes, including the avoidance of double taxation, reduction of withholding taxes, exchange of information, and the establishment of a mutual agreement procedure for dispute resolution. The specific terms and provisions of each tax treaty can vary, so individuals and businesses engaged in cross-border activities are advised to consult with tax experts or legal professionals familiar with the details of the relevant treaty to ensure compliance and optimize tax efficiency.
Overview of the US tax system
We would like to conclude this article with the same observation that we started it with. Taxation in the United States can be very complex, and if you are new to the country, it may take you some time to fully understand how things work. Many US residents use professional tax preparation services and advisors. This helps make sure that all the appropriate taxes are paid and all possible credits and deductions are filed.
It is highly advisable for expats living in the US to hire a specialist familiar with expat taxes to help them through this process.
Useful links:
Internal Revenue Service (IRS) homepage
IRS - Information for international taxpayers
IRS - Information for taxation of non-resident aliens
Turbotax tax preparation software
Last update on 23 February 2024 14:31:26