Tax Liability: Definition, Meaning, Calculation, and Example

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Tax Liability: Definition, Meaning, Calculation, and Example

What Is Tax Liability?

A tax obligation is a payment owing to a federal, state, or municipal tax body by a person, corporation, or other organization.

In general, you have a tax obligation when you make income or profit through the sale of an investment or other item. If you do not satisfy the income criteria to file taxes, you may have no income tax obligation.

Key Takeaways

  • The entire amount of tax obligation owing to the government by a person, company, or other organization is referred to as tax liability.
  • Tax responsibilities include income taxes, sales taxes, and capital gains taxes.
  • Taxation is levied by a variety of taxing entities, including the federal, state, and municipal governments. Taxes create revenue for services such as road repair and military maintenance.
  • By claiming deductions, exemptions, and tax credits, you may reduce your tax payments.

Understanding Tax Liability

Various authorities, including the federal, state, and municipal governments, levy taxes and utilize the proceeds to support services such as road repairs, social programs, and military operations.

Companies deduct income taxes, Social Security and Medicare levies, and submit them to the federal government.

It’s crucial to understand that your tax burden extends beyond the current year. Instead, it takes into account any years for which taxes are payable. That implies that any back taxes (any unpaid taxes from prior years) are added to your tax burden.

How to Calculate Your Tax Liability

The tax on earned income is the most prevalent tax burden for Americans. The Internal Revenue Service’s tax rates and standard deductions are used for federal taxes.

Standard deductions for 2022 are:

  • $12,950 for single filers
  • Married couples filing separately must pay $12,950.
  • $19,400 for household heads
  • For married couples filing jointly, the tax is $25,900.
  • $25,900 for surviving spouses

2022 Tax Brackets
Tax RateSingle Filer in 2022 Married Filing Separately in 2022Married Filing Jointly in 2022Head of Household in 2022
10%$10,275 or less$10,275 or less$20,550 or less$14,650 or less
12%Over $10,275Over $10,275Over $20,550Over $14,650
22%Over $41,775Over $41,775Over $83,550Over $55,900
24%Over $89,075Over $89,075Over $178,150Over $89,050
32%Over $170,050Over $170,050Over $340,100Over $170,050
35%Over $215,950Over $215,950Over $431,900Over $215,950
37%Over $539,900Over $323,925Over $647,850Over $539,900

Assume you’re a single taxpayer making $72,950 per year. Your reportable income is $60,000 after deducting your standard deduction of $12,950. You also have no additional income or deductions. You are in the 22% tax bracket because your adjusted gross income is between $41,775 and $89,075. Your tax burden is calculated for each tax bracket up to and including the one you are in. This is how it works:

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  • Because the first $10,275 is taxed at 10%, you owe $10,275 x 10% = $1,028.
  • Over $10,275 but less than $41,775 is taxed at 12%, thus you owe $31,500 x 12% = $3,780.
  • Over $41,775 but less than $89,075 is taxed at 22%, thus you owe $18,225 x 22% = $4,010.
  • You add up the amounts you owe in each bracket: $1,028 + $3,780 + $4,010 = $8,818
  • Your total tax obligation is $8,818 plus any backtaxes.

Liability or Refund?

Assume your employer withheld $7,500 in federal taxes as a consequence of your W-4. You owe taxes because you did not meet your tax obligation when you filed your individual tax return (Form 1040). You’d owe $8,818 – $7,500 = $1,318 in this situation.

If your employer withheld $9,200 in federal taxes as a consequence of your W-4, the IRS would repay you $9,200 – $8,818 = $382.

Locate your state’s standard deductions and tax information and follow the directions supplied by the state to determine your state tax due. Some states have a flat tax, while others have progressive rates.

How Capital Gains Are Taxed

When you sell an investment, real estate, or other item for a profit, you must pay taxes on the profit. If you sell it at a loss, you may deduct the amount as a capital loss. Capital gains are taxed differently depending on whether they are long-term or short-term. If you own an asset for one year or less and sell it for a profit, the gain is considered a short-term capital gain and is included in your income.

If you own an asset for more than a year then sell it for a profit, it is called a long-term capital gain and is taxed. There are capital gains thresholds, which are analogous to income tax rates.

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Capital Gains Tax RateSingle File Taxable IncomeMarried Filing Separate Taxable IncomeHead of Household Taxable IncomeMarried Filing Jointly Taxable Income
0%$41,675 or less$41,675 or less$55,800 or less$83,350 or less
15%$41,675 to $459,750$41,675 to $258,600$55,800 to $488,500$83,350 to $517,200
20%$459,750 or more$258,600 or more$488,500or more$517,200 or more

Here’s how it works: suppose you buy 100 shares of XYZ common stock for $10,000 and sell them for $18,000 five years later. The $8,000 profit is taxed. The gain is a long-term capital gain since you kept the stock for longer than a year.

Using the prior example, if your AGI is $60,000, your capital gains tax rate is 15%. As a result, you’d have to pay 15% of $8,000 in taxes, or $1,200. If you had kept the stocks for less than a year, you would have included the $8,000 in your gross income before deducting your standard deduction.

So, if you made $72,950 and received $8,000 in short-term capital gains, your total income is $80,950. If your filing status and other deductions remained the same as in the previous example, you’d still be in the 22% tax bracket and would proceed with the computations as before.

How to Reduce Your Tax Liability

Taxes may significantly reduce your take-home income, but they are something that everyone must accept in order to support the government services on which we depend. However, there are a few options for lowering your tax burden.

Deductions and Credits

Other deductions or credits may be available to you. Deductions lower your taxable income, while credits lower the amount of tax you owe. You may be eligible to take the following deductions:

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  • Business expenses
  • Using your automobile for work reasons
  • Using your home for commercial reasons
  • Itemized deductions
  • Education deductions
  • Health care deductions
  • Investment deductions

Some credits are:

  • Family and dependant credits
  • Income and savings credits
  • Homeowner credits
  • Health care credits
  • Education credits

Contribute to a Retirement Fund

Contributing to a retirement fund does more than only help you prepare for and expand your retirement nest egg; it may also minimize your tax bill for years to come if properly structured. You may contribute a certain amount to your IRA each year, which is tax-deferred. After you’ve paid your taxes, you contribute to a Roth IRA.

To reduce your tax obligation by donating, just predict your income and withdrawals to see how much you expect to be taxed in retirement. If you are now in a higher tax band than you will be in retirement, a conventional IRA may reduce your overall tax payments because:

  • Taxes are deferred
  • You’ll be in a reduced tax band later on, with less tax burden.

If you know you’ll be in a higher tax band after you retire and start taking withdrawals, a Roth IRA may help you save money since withdrawals are tax-free.

How Is Tax Liability Determined?

Your tax burden is calculated by deducting your standard deduction from your taxable income and referring to the relevant IRS tax rates.

How Do I Know If I Have No Tax Liability?

If you are not obliged to submit income taxes or have no taxable income for the tax year, you have no tax responsibility.

How Do I Reduce My Tax Liability?

Contributing to a retirement or health savings account is one option to lower your tax obligation. You may also minimize your taxable income by using credits or other deductions.

The Bottom Line

The amount of taxes you owe on your taxable income for the year is referred to as your tax obligation. If you make money, you will have to pay taxes.

To calculate your taxable income, put all of your income together and subtract your standard deduction. Then, use the IRS tax brackets to determine your tax obligation.

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