For many taxpayers, the commencement of tax season brings its own unique set of challenges and hurdles. Whether you are handling your own tax return or hiring a seasoned professional to attend to these matters, it is important to assess what you will be expected to pay in a given year.
One of the most frequently asked questions that comes up when looking into these tax projections is “What is tax liability?” It is highly possible you have heard the term tax liability used many times over the years, but you may be unsure what it means, what factors are involved, and how they apply to you as a responsible taxpayer.
What Is Tax Liability?
Defined
In simple terms, the basic answer to “What is tax liability?” is the comprehensive debt that you as the taxpayer owe to a local, state, or national tax authority. The most common tax authority that comes to mind is the Internal Revenue Service, but there are others which you may be subject to depending on the state and the area in which you live. Tax liability is the sum of all that you owe to that government authority.
As a citizen and taxpayer, you are legally required to satisfy the reporting requirements associated with any taxable event, such as income you have earned, sales of possessions or property, payroll activity, and so forth. Typically, a taxable event is multiplied by its associated tax rate to create your projected amount of tax liability.
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Analysis
Individuals and businesses are both equally affected by the question “What is tax liability?” as their total amount owed is governed by local, state, and federal laws. Whenever you engage in a taxable event, such as receiving income, it is important to understand the base and rate of the tax you will be expected to pay.
Additionally, it is imperative to recognize that tax liability is not limited to a yearly assessment. Rather, your tax liability will include any additional years you or your business failed to pay sufficient taxes. If you have back taxes owed, this will be tacked on to your tax liability for that year, increasing your debt considerably.
Tax liability is enforced by tax authorities to support the social and administrative sectors of the government. In fact, taxes fund a wide variety of government functions and play an essential role in the effective running of any ruling entity. Failure to adhere to the guidelines imposed under your tax liability can cause excessive fines, a liquidation of your assets, and even result in imprisonment in severe cases.
It is not uncommon for businesses to try to reduce their tax liability by utilizing various tax shelters, charitable contributions, and credits. Some even incorporate their businesses in countries that serve as tax havens that implement minimal to nonexistent tax liability regulations. Whether or not this applies to you, understanding “What is tax liability?” and the key factors that affect your associated responsibilities as an individual or business owner are essential to ensure that you are not found an owing or truant taxpayer.
What Affects Tax Liability?
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Income Tax
The first contributing factor we will discuss to expand upon the query “What is tax liability?” is the all-important income tax. Bear in mind, your tax liability is dependent on more than your income tax, but this comprises the most significant factor in determining the amount you ultimately owe.
Your income tax is measured by your particular tax bracket. Your tax bracket is determined by how much of your income is taken out in a given year to meet taxation requirements. Your income tax and its resulting effect on your tax liability will also depend on your aggregate annual income and filing status. The more money you earn in a given year, the higher your tax bracket percentage will be. This increases the amount of taxes you are liable for and will owe when next filing.
Capital Gains Tax
The next key factor which affects the question “What is tax liability?” is capital gains taxes. Capital gains taxes can increase your overall tax liability if you dispense with assets above and beyond the amount of your interest in those holdings.
Whether you are selling an investment property or some other type of financial asset, you will pay taxes on the money received in the transaction. For instance, if you were to make an investment of $6,000 and sell the asset 2 years later for $8,000, you would have reached $2,000 in long-term capital gains. This total will be taxed under your capital gains at a rate dependent on your earned income for the year.
The higher your income received through asset gains, the higher your tax rate and resulting tax liability will be. If you were to sell an asset after holding it for under a year, it would be considered a short-term capital gain taxed along with your regular income and associated tax bracket.
Additional Key Factors
Your income taxes and capital gains taxes are not the only factors which affect the question “What is tax liability?” Taxes like the self-employment tax if relevant, tax penalties, or tax interest will help determine the amount which you are liable for.
If you chose to enroll in a payment plan for the previous year’s taxes, you will be charged a significant rate of interest to be included in your overall tax liability. If you were to make an early withdrawal from your retirement account, resulting in a strict penalty deducted from the overall percentage, the resulting allotment would still be considered as part of your tax liability.
How Much Will I Have To Pay?
Consider Your Deductions
In answering the query “What is tax liability?” you are likely wondering what the total amount you will be expected to pay might be. Despite the fact that your income and tax bracket make a huge difference in the sum you owe, you can reduce this remainder by considering your potential tax deductions.
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While the Tax Cuts and Job Act passed in late 2017 removed the ability to deduct personal exemptions, you still have plenty of opportunities to use this legislation to your advantage when filing your next tax return. This act altered the pre-existing tax brackets to allow you to earn a higher income before being taxed at a greater percentage rate. This means that the opportunity to make a standard deduction from your overall tax liability is almost twice as much as it was before.
For example, the typical standard deduction for an individual was $6,350 in 2017, but increased to $12,000 in 2018. In simple terms, this means that your tax liability is reduced by the standard deduction you make. Your total liability can be reduced further by any itemized deductions you include. Once you have reduced your total tax liability by these standardized figures, and additional deductions or credits, your amount owed to the government can drop considerably.
Remember Tax Credits
Tax credits are an invaluable tool in examining the question “What is tax liability?” While deductions only reduce your income subject to taxation, credits may be deducted straight from your overall tax liability.
For example, suppose you have already factored in your standard deduction and any other deductions relevant to your income situation, leaving you with a total tax liability of $5,000. If you qualify for a tax credit of $1,000, you will lower your tax liability down to $4,000. If you use tax credits to reduce your total tax liability, the government views it as if you had submitted an actual tax payment.
Calculating Your Total
The last key point to discuss regarding “What is tax liability?” is how to calculate your total on the federal IRS tax return Form 1040. The first thing you need to know is that the sum of Line 52 through Line 62 will determine your total tax liability amount.
Once you have factored in any relevant deductions and tax credits, you will alter your total tax liability amount to reflect those reductions. Finally, you will need to enter the grand total on Line 63 of the final page of Form 1040.
Conclusion
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Understanding “What is tax liability?” — how it affects you, and the way to calculate it on your tax return, is essential knowledge to possess as a taxpayer and citizen. If you miscalculate and overpay your projected taxes owed, you will receive a nice refund at the end of tax season. This is highly preferable to underestimating your total tax liability and receiving an unwelcome notification from a tax authority like the IRS that you owe a steep sum in back taxes.
The good news is, with the recent legislation afforded by the Tax Cuts and Job Act, taxpayers have more options for standardized deductions than ever before. By taking the time to calculate your standard and other relevant deductions, tax credits, or any estimated payments if you are self-employed, you will reduce your overall tax liability considerably.
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