A tax rate is the percentage of your taxable income, which in a progressive system like that used in the United States, may increase or decrease with increases or decreases in taxable income. Under this system, percentage of tax taken from your income or tax rate is based on the amount you make, which is described in tax brackets. People who make very small amounts of money may have low tax rates, and those who make a significant amount of money will typically pay more in taxes, unless they find tax loopholes or shelters that allow them to invest or protect some of their money from being considered as taxable income.
Tax rates are not quite that simple. In the US system for example, people’s incomes are taxed at progressive rates. This means, they pay a percentage of tax for money made within each bracket. Money made above a particular bracket is taxed at a higher rate. All your income isn't typically all taxed at one single tax rate — money made below a tax bracket gets taxed at lower rates, and money above that bracket gets taxed at higher rates.
The following is a simplified example: Say you are taxed at 10% for the first $10,000 US Dollars (USD) of your taxable income, and 12% for money made above $10,000 USD. Your taxable income is $15,000 USD. You can’t simply state that your tax rate is 12% or 10%. Instead you pay $1000 USD on the first $10,000 USD made, and $600 USD on the $5000 USD made thereafter. Your total rate is the sum of the tax paid, divided by total income: 1600/15,000, or roughly 10.67 %.
In a flat tax system as opposed to a progressive system, rate remains constant no matter what your income. If flat tax is 10%, then you can always count on owing 10% of your income in taxes, no matter what you make. A number of other systems may exist that can be based on tax bracket, income, and a variety of other factors. Something of a flat tax system is employed when people must pay sales tax. At least within a state or particular city, the same tax rate will be applied to all qualifying purchases. No one will pay more or less to buy the same blender or television set, at the same store with a set sales tax.
In considering tax rate and income, it’s a good idea to evaluate the difference between your gross income and taxable income. Taxable income is that amount you make once you have taken all available deductions, such as those for supporting children, losing money in the stock market, and standard allowable deductions for each taxpayer. Such deductions have to be considered, because in progressive systems, there’s a huge difference between a tax rate on the much higher income that represents your gross earnings. Even if your gross income technically falls in a higher tax bracket, that doesn’t mean that your net or taxable income will. On the other hand, if your gross income falls in a lower bracket but you’ve received large bonuses, inheritances or made a killing in the stock market, taxes may be assessed at a higher bracket than one you would normally expect.
Some people are curious as to why understanding tax rate is important. It can be essential to understand it, especially if you’re attempting to lower your taxes, or plan for the amount of taxes you may owe at the end of the year. Moreover, if you do suddenly make a lot of money or inherit quite a bit of money or property, you may want to prepay taxes on that amount to not be hit by a huge tax bill at year’s end. Understanding the rate at which you are taxed can also be an asset in financial planning, since it can help you form a realistic picture of what your income truly is after taxes are assessed.
