Taxes are confusing, but you are not alone. In this article, we clear up some basic terminology and explain the meaning of tax liability. We also explain how you can estimate your tax liability so you would not be facing a huge tax bill when it is time to submit your tax return or pay too much throughout the year just to get it refunded back to you the next year.
What is tax liability?
We have already mentioned the term tax liability several times, but what does it mean? It is the amount of taxes business owners and all the other taxpayers have to pay to the government. It is typically implied that it is computed for one year. Current tax liability is an unpaid tax in respect of the current period and prior period. An opposite term would be current tax asset, which is excess tax paid in respect of the current period and prior period.
Another frequently used term in business records is deferred tax liability. Deferred can be defined as anything that has been postponed and liability means one owes something. Taxes that are currently not due is deferred into a later year. Why? The profit a company recognizes in its accounting books is not the same as the profit you recognize for tax purposes. This results in temporary differences between book and tax profit amounts. In the long term, the results will be the same and all the numbers will even out.
What is tax due?
It might seem these two terms mean the same thing, which is not true. Throughout the year, you earn money through business, working for your employer, or through a variety of other sources. If you earn a W-2 income, your employer keeps a portion of your salary (wage) as taxes. If you are a business owner, you pay estimated taxes several times a year (at least you should be) to help you make an IRS bill at the year-end more realistic to pay. These both are considered pre-payments to your eventually tax due, which you find out when you prepare your taxes the next year.
When filing, you calculate how much is owed based on your various income sources. This amount is known as a tax liability. You then take that amount and deduct the withholding your employer did from your paycheck and/or the estimated tax payments sent throughout the year. This then leaves you with a refund or an amount due.
If you have a refund, then you paid too much when you were making those pre-payments and the IRS is giving your rightfully earned money back. If you have an amount due that means your withholdings or estimated tax pre-payments were not able to cover the total tax liability. So, now there is an additional amount due to make sure your IRS bill is fully covered.
How do you estimate tax liability?
Once you understand the basic fundamentals of taxes and preparing returns, then the details of a long and confusing tax law get much more manageable. Let’s go over the basic steps you would take.
- The first step would be to determine your taxable income. To calculate it, you use the formula: Adjusted Gross Income – Deductions & Exemptions. The gross income means the total amount you earned before any taxes are taken out. The words adjusted, deductions and exemptions represent all the different ways you can reduce a gross income, which gets taxed by the government.
- Once you figure out your taxable income, you use yet another equation to arrive at your tax liability, which is Taxable Income x Tax Rate. As you might already know, the tax rate you would need to use in the equation depends on your income.
- So, what amount should you write the check for when filing your taxes? The payments you have already made along with any tax credits you are allowed to claim are subtracted. If what you paid plus the credits is less than your tax liability, then you owe the government the difference. If what you paid through credits and payments is more than your liability, then you get money returned to you (or you can apply it towards the next tax bill).
Tips for making tax liability lower
Who does not want to pay fewer taxes? Let’s review some legal ways to do it.
- Tax-exempt income. One of the strategies you can use is to switch over to certain types of money sources that the government does not tax.
- Deductions. You want to maximize all your deductions because the more deductions you take, the less you have to pay.
- Invest in 401K plan. You can make contributions towards your retirement to reduce your taxable income and, ultimately, your tax liability. The government encourages taxpayers to save for the time when they retire.
- Invest in SEP IRA. If you are a freelancer or self-employed or your employer does not offer 401K, then you can consider SEP IRA. Just like with the 401K, any contributions you make lead to a lower income amount you use for calculating the tax liability.
- Donate. Donations are yet another way to reduce one’s income and make our world a better place. As with any items on the list, there are some rules you should be aware of to take advantage of the opportunity.
- Health savings account. This is a tax-advantaged medical savings account. It exists to make healthcare costs much more affordable.
If you would like to make tax liability more bearable, then it is always advisable to talk to a tax expert ahead of time and get professional advice. They can develop a strategy for you and help you keep more money in your pocket in a right and legal way.