So rather than paying a fixed dollar amount, you pay a percentage of your income in taxes, and that percentage is your tax rate. A tax rate can apply to many other areas of taxation, such as sales tax on goods and services you buy and property tax on real estate you own, in which you would also pay a percentage of the taxable value. For example, if you buy a TV in New York City for $400, you would pay a sales tax rate of 8.875%, which would equal $35.50. Yet if you made the same purchase in New Jersey, you would pay a sales tax rate of 6.625%, which would equal $26.50 in sales tax.
How Progressive Tax Rates Work
A tax rate is set by governments that determine what percentage to charge for taxable items like income, purchases, and property. For example, the U.S. federal government taxes income using progressive tax rates. That means that tax rates get increasingly higher as income levels go up. For tax years 2022 and 2023, the lowest tax rate is 10% and the top income tax rate is 37%. However, it’s important to realize that earning more income doesn’t mean that all of your income will be assessed at higher tax rates. The first $10,275 of your taxable income (if you’re a single filer) would be taxed at 10%, and then you would be taxed progressively more as your taxable income increases. The tax rate on income over $10,275 and up to $41,775 for single filers is 12%. So if you have a taxable income of $40,000 per year, a $5,000 raise would mean that not all of your income would be taxed at the next tax rate of 22%. Instead, only the amount over $41,775 (i.e., $3,225) will be taxed at a rate of 22%.
What Tax Rates Mean for Individuals
Understanding tax rates can help you figure out the best ways to reduce your tax bills legally. For example, if you took all of the money out of your 401(k) at once, you would owe income tax on the full amount. So if you had several hundred thousand dollars in that account, you might have to pay the top income tax rate of 37%. However, if you took distributions slowly over several years, you could potentially stay below that top tax rate and save money on taxes. Similarly, understanding tax rates for things like property taxes and sales taxes can help you make better financial decisions. This can include budgeting with sales tax in mind rather than just accounting for the sticker price of a big purchase. Consider consulting a financial advisor to help guide you through tax-saving strategies that fit your situation.
