Your tax liability is the amount of tax you or your company owes a taxing authority, like the Internal Revenue Service (IRS), state government, or local government. You pay a tax liability when you earn income, whether that’s through a sale or another taxable transaction. Taxing authorities require you to pay a portion of those earnings to Uncle Sam.
It’s possible to have no tax liability. That means your tax liability from the previous year was zero. You may also have zero tax liability if you fail to file a state or federal income tax return.
Like it or not, taxes are here to stay. The problem is that the government doesn’t tell you how much you’ll owe. It can’t. That means you have to determine your tax liabilities by yourself to avoid paying penalty fees. Here's how tax liabilities work and how you can reduce the amount you owe during tax season.
How Does Tax Liability Work?
If you have a regular job—meaning you’re not a business owner or freelancer—your employer will deduct a portion of your income on your behalf. They set aside this money for tax purposes. Your employer sends these withholdings to the IRS and other taxing authorities during tax season.
Your income tax liability depends on your gross income. An employer will withhold a percentage of your earnings based on your Form W-4 information. You can find out how much your employer deducts by looking at line 25a of your tax return.
If you run a small business or freelance, you’re on your own when calculating your income tax liability. You pay taxes every three months, also known as quarterly tax payments. These payments estimate your liabilities for the quarter and reduce your tax liability come April.
Accurate calculations can make a world of difference for your bottom line. If you send the IRS less money than your tax liability, you'll have to cut the taxman a check for the difference in April. If you send the IRS more than your tax liability, you’ll receive a refund. That’s no good either because that money could have gone to more pressing needs.
Let’s say your total tax payments added up to $7,000 during the year. If you have a $5,000 tax liability, you’ll earn a $2,000 refund. Conversely, you might have made $3,500 in tax payments and have a tax liability of $5,000. In that case, you would owe the IRS $1,500 after applying tax credits.
What Can Affect Your Tax Liability?
Your income tax has the most influence on your tax liability. It also determines your tax bracket, meaning the percentage of income you pay in taxes. Tax brackets depend on your filing status and income over the past calendar year, which you report on a Form 1040 on your income tax return.
As of 2020, you would pay a 10% income tax if you made less than $9,875 per year. If you earned between $40,126 to $85,525, you pay up to 22% on a portion of your taxes. Note that you do not pay 22% on all your taxes, only the amount you earned that was over $40,126.
Self-employed individuals have their own tax bracket. They pay a flat rate of 15.3%. That rate includes Social Security and Medicare taxes, translating to 12.4% and 2.9%, respectively. No matter how much money you earn while self-employed, you will pay the same rate.
Here’s where taxes get tricky. Your income isn’t the only thing that impacts your tax liability. The amount of money you owe equals your earnings minus the standard deduction or your itemized deductions.
Examples of itemized deductions include:
- Medical expenses
- Dentist bills
- Real estate mortgage interest
- Property taxes
- Gifts via cash or check
- Losses due to federally declared disasters
As of 2020, the standard deduction for single filers is $12,400. Now, let’s say you belong to the 10% tax bracket, meaning you earned less than $9,875 last year. Because the standard deduction exceeds your income, you would have a negative balance and no tax bill.
You can adjust your tax returns on the Schedule 1 form for Additional Income and Adjustments to Income. These extra lines go on top of your standard deduction or itemized deduction. They can include self-employment tax, student loan interest deductions, and teaching expenses.
Examples of Income Tax Liability
Determining your tax liability requires two pieces of information: your taxable income and tax deductions. Once you know those figures, subtract the deductions from your taxable income. The result is your gross tax liability.
Let's say you have $50,000 in taxable income, and you file by yourself. If you take the standard deduction of $12,400, you’ll reduce your taxable income to $37,600. That figure places you in the 12% tax bracket because it falls between $9,876 and $40,125.
You will pay 10% tax on your first $9,875 of income. That comes out to $987.50 in taxes. You also have to pay 12% on the remaining $27,724. That translates to $3,327 in taxes.
Next, you combine your taxes due from each bracket ($987.50 and $3,327) for a total of $4,314.50. That's your tax liability. Of course, that figure may go up or down depending on your exemptions, deductions, and tax credits.
Some types of tax liabilities include earned income tax, capital gains tax, self-employment tax, installment agreement interest tax, and early retirement distribution penalties.
Capital Gains Tax
You pay a capital gains tax when you earn a profit from the sale of a capital asset. That asset could be a piece of land, artwork, a business, or cryptocurrency. Most of the time, the capital gains tax is lower than the rate you pay for income.
Capital gains taxes come in two forms – short-term and long-term. You pay a short-term capital gains tax of up to 37% if you hold the asset for one year or less. If you keep that asset for at least a year, you'll only pay up to 20%.
Again, your tax liability depends on your tax bracket and total taxable income. For example, a married couple that files jointly and earns more than $500,000 will pay the maximum capital tax rate. However, someone that files alone and has an income below $40,000 will pay zero capital gains tax.
Early Distribution Penalty
Do you have a Roth IRA or another retirement account? If you withdraw your money before age 59.5, you have to pay a 10% penalty. You must add that penalty fee to your total tax liability.
Installment Agreement Interest
Some people can’t pay their tax liability by April 15 of each year. If you do not file an extension, you have to pay interest. That interest begins on April 15 and continues until you pay your outstanding obligations.
People use installment agreements to pay down their previous year’s taxes. A tax professional may help you reduce your overall taxes and penalties. If that happens, the IRS will automatically reduce how much interest you must pay.
How to Reduce Your Tax Liability
Deductions and tax credits are your best friends when trying to reduce your tax liability. They can help you move down to a lower tax bracket. That means you’ll pay a lower percentage of taxes on a portion of your earnings.
Most people take a standard deduction to reduce their tax obligations. Single filers can claim $12,400, and married couples filing jointly can claim $24,800. If you opt for itemized deductions, such as gifts to charity and medical expenses, you probably won't reduce your tax liability by as much.
Tax credits offer another avenue to reduce your tax liability. They serve as a dollar-for-dollar reduction of your tax debt, lowering your obligations at the federal and state level. You can apply tax credits to your final tax bill for things like adopting a child, buying a home for the first time, and having children.
Finally, you can slash your tax liability with retirement account contributions. If you have a 401(k), you can put your pre-tax dollars into the account and let it grow tax-free until you withdraw it. The process enables you to defer taxes until you take out the money.
The same process does not apply to a Roth IRA. Those contributions involve post-tax dollars. While a Roth IRA (or other similar retirement accounts) won’t help reduce your tax liability, they help you avoid paying taxes on your earnings when you withdraw the funds.
Deferred Tax Liability
A deferred tax liability includes any tax that you owe but that you don’t have to pay right now. It becomes due at a specified time in the future. The deferral comes when you accrue a tax obligation and when you pay it.
For example, you might run a business that pays 30% in tax. You could pay tax on your $10,000 profit this year or wait until the next one to report it. Deferring your tax allows you to free up $3,000 for investments in your business instead of paying taxes.
You would report a $10,000 profit on your tax returns. You still don’t have to pay the tax liability immediately. Instead, you must show a $3,000 balance for “spoken for” future cash, securing the deferred tax liability.
Your tax liability is the amount of money you owe to Uncle Sam. You can have a zero tax liability if your earnings were less than what was owed, or you had no taxable transactions in that calendar year. It’s possible for someone not to file a state or federal income tax return and still have a non-zero tax liability because they earned so much during the year (or from some other source). If this sounds like you, it's important to understand how taxes work and make sure all your bases are covered. Let us know if we can help!