Tax Liability: Definition, Calculation, and Example

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What Is Tax Liability?

A federal tax liability is an amount that's owed to the government in taxes. It can include income taxes on earnings and capital gains taxes on assets. Both are based on brackets, a percentage of the money earned, and brackets are determined by various factors.

A liability can be owed by an individual, business, or other entity. It can be owed to a state or local tax authority as well as to the federal government.

You generally have a tax liability when you earn income or generate profits by selling an investment or other asset. It's possible to have no tax liability if you don't meet the income requirements or brackets to file taxes.

Key Takeaways

• Tax liability is the amount of tax debt owed to a government by an individual, corporation, or other entity.
• Income taxes, sales tax, and capital gains tax are all forms of tax liabilities.
• Taxes are imposed by various taxing authorities including federal, state, and local governments.
• Taxes generate the funds necessary to pay for services such as repairing roads and maintaining a military.
• You can lower your tax liabilities by claiming deductions, exemptions, and tax credits.

Understanding Tax Liability

Federal, state, and local governments impose taxes and use the money that's raised to pay for services such as repairing roads, funding social programs, and maintaining a military.

Companies withhold income taxes, Social Security taxes, and Medicare taxes from employees' wages and send the money to the federal government to cover their tax liabilities.

Social Security and Medicare are taxed at a flat rate that's more or less applicable to all taxpayers but U.S. federal income tax rates are progressive. A higher income will put you in a higher tax bracket on your top-earned dollars. The percentage owed for taxes and your federal tax liability will become greater if you earn more.

Your tax liability doesn't just include your income and earnings in the current year. It factors in any past years for which taxes are owed. Any unpaid taxes from previous years are also added to your federal. tax liability if back taxes are due.

How to Calculate Your Tax Liability

The most common federal tax liability for Americans is the tax on earned income. You can use the tax brackets and standard deductions issued by the Internal Revenue Service (IRS) to get an idea of what yours will be for a given year.

The standard deductions for 2024 are:

• $14,600 for single filers
• $14,600 for married couples filing separately
• $21,900 for heads of households
• $29,200 for married couples filing jointly

Standard deductions for 2023 were:

• $13,850 for single filers
• $13,850 for married couples filing separately
• $20,800 for heads of households
• $27,700 for married couples filing jointly

These standard deduction amounts are subtracted from the total of your earned income and you're only taxed on the remaining balance. The amount you can deduct depends on your filing status. You also have the option of itemizing your deductions instead of claiming the standard deduction, but you can't do both. Many filers find that their standard deductions are larger than the amount of itemized deductions they're eligible to claim.

Tax bracket income ranges are adjusted annually to keep pace with inflation so they're slightly more generous in 2024 than they were in 2023:

Imagine you're a single filer in 2024 and you're earning $80,000 per year. Your reportable income is $65,400 after subtracting your standard deduction of $14,600. You have no other deductions or income.

You fall into the 22% tax bracket because our adjusted gross income ($65,400) falls between $47,150 and $100,525. Your federal tax liability is computed for each tax bracket.

• Your first $11,600 is taxed at 10% so you owe: $11,600 x 10% = $1,600
• The amount over $11,600 but under $47,150 is taxed at 12% so you owe: $35,550 x 12% = $4,266
• The amount over $47,150 but under $100,525 is taxed at 22% so you owe: $18,250 x 22% = $4,015
• Total up each amount you owe per tax bracket: $1,600 + $4,266 + $4,015 = $9,881
• Your total tax liability for 2024 is $9,881 plus back taxes if any
  

Liability or Refund?

Now assume that your W-4 resulted in your employer withholding $7,500 in federal taxes. This isn't enough to meet your federal tax liability when you file your Form 1040 individual tax return so you'd owe $2,381 in taxes: $9,881 - $7,500 = $2,381.

The IRS would refund you $119 if your W-4 resulted in your employer withholding $10,000 in federal taxes: $10,000 - $9,881 = $119.

Locate your state's standard deductions and tax information and use the instructions provided by the state to calculate your state liability. Some states have a single tax rate, others have graduated brackets like the federal government, and some have no income tax at all.

How Capital Gains Are Taxed

You'll owe taxes on the gain when you sell an investment, real estate, or any other asset for a gain. You can report it as a capital loss if you sell it for a loss. Capital gains are taxed in two ways. They're either long-term or short-term. It's a short-term capital gain if you hold an asset for one year or less before selling it for a gain. It's considered a long-term capital gain and is subject to the capital gains tax if you hold it for more than one year before selling it for a gain.

Capital gains thresholds similar to income tax brackets apply to long-term gains.

Assume you purchase 100 shares of XYZ common stock for $10,000 in 2019. You sell them five years later in 2024 for $18,000. The $8,000 gain is a taxable event. You held the stock for more than one year so the gain is a long-term capital gain.

Your capital gains tax bracket is 15% if you're a single filer with an adjusted gross income of $65,400. You must pay 15% of your $8,000 gain in taxes, or $1,200. You'd include the $8,000 in your gross income before subtracting your standard deduction if you held the stocks for one year or less. This figure is added to your federal income tax liability in either case.

How to Reduce Your Tax Liability

Taxes can take a significant bite out of your take-home pay but it's something everyone has to live with. You can reduce the amount of taxes you pay in several ways, however.

Deductions and Credits

You might qualify for other deductions or credits. Deductions reduce your taxable income and credits reduce the amount of tax you owe. Some deductions you might be able to claim include:

• Business expenses
• Using your car for business purposes
• Using your home for business purposes
• Itemized deductions
• Education deductions
• Healthcare and health insurance deductions
• Investment deductions

Some available tax credits include:

• Family and dependent credits
• Income and savings credits
• Homeowner credits
• Healthcare credits
• Education credits

Contribute to a Retirement Fund

Contributing to a retirement fund does more than help you save for and grow your retirement nest egg. You can reduce your federal tax liability for years to come if you plan carefully. You can contribute a specific amount per year to your traditional IRA and this amount is tax-deferred. You can contribute to a Roth IRA after you've paid taxes on that money.

Determine how much you believe you'll be taxed in retirement by projecting your income and withdrawals to lower your tax liability by contributing. A traditional IRA can lower your total tax payments if you're in a higher tax bracket now that you will be in retirement because:

• Taxes are deferred to your retirement years.
• You'll be in a lower bracket with less tax liability at that time.

A Roth IRA can lower your total tax payments if you're sure you'll be in a higher tax bracket after you retire and begin taking withdrawals because those withdrawals will be tax-free.

How Is Tax Liability Determined?

You can determine your federal tax liability by subtracting your standard deduction from your taxable income and referring to the appropriate IRS tax brackets. The IRS provides an estimating tool on its website.

How Do I Know If I Have No Tax Liability?

You have no tax liability if you aren't required to file an income tax return or have no taxable income for the tax year.

How Do I Reduce My Tax Liability?

Some ways to reduce your tax liability include contributing to a retirement or health savings account. You can also use credits or other deductions to reduce your taxable income.

The Bottom Line

Your federal tax liability is the amount of taxes you'll owe on your taxable income for the year. You'll have some tax liability if you earn income.

Add all your income and subtract your standard deduction to figure out your taxable income. Then refer to the IRS tax brackets to find your tax liability. You might speak to a tax professional if the amount is more than you think you can handle and the IRS also offers a variety of payment plans if you're really in a jam.

1. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2024."
2. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2023."
3. Internal Revenue Service. "Credits and Deductions for Individuals."
4. Internal Revenue Service. "Part III, Administrative, Procedural, and Miscellaneous, Tax Forms and Instructions." Pages 5-6.
5. Tax Foundation. "State Individual Income Tax Rates and Brackets, 2024."
6. Internal Revenue Service. "Part III, Administrative, Procedural, and Miscellaneous, Tax Forms and Instructions." Pages 7-8.
7. Internal Revenue Service. "Topic No. 409 Capital Gains and Losses."
8. Internal Revenue Service. "Traditional and Roth IRAs."
9. Internal Revenue Service. "Frequently Asked Questions / Penalty Questions."

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A qualified higher education expense is a tax credit for the parents of students attending a college or other post-secondary institution.

A widow(er)'s exemption is one of several forms of state or federal tax relief available to a surviving spouse in the period following their spouse's death.

Passive income is earnings from a rental property, limited partnership, or other enterprise in which a person is not actively involved.

A filing extension is an exemption made for taxpayers who are unable to file their federal tax return by the regular due date.

A flow-through entity is a legal business entity that passes income to the owners and/or investors of the business. It's sometimes referred to as a disregarded entity.

A tax rate is a percentage at which an individual or corporation is taxed. A progressive tax rate imposes additional, higher rates as income increases.

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