The Ultimate Guide to Tax Liability

The term “tax liability” describes the amount of money owed to the Internal Revenue Service (IRS) at the end of each tax year. Many Americans make reducing their tax liability a goal by chasing deductions and tweaking their filing strategy. If you want to know the answer to the question “Do I have tax liability?” you’ll have to compare your income to the deductions, exemptions and credits for which you’re eligible. A financial advisor could help reduce your tax liability by creating a full financial plan for your goals.

Tax Liability Definition

The definition of tax liability is the amount of money or debt, an individual or entity owes in taxes to the government. In general, when people refer to this term they’re referring to federal income tax liability. If your income is low enough you won’t have any tax liability at all. Your standard deduction will exceed your taxable income, leaving you with nothing owed to the IRS. Millions of Americans are in this situation. They don’t pay federal income taxes and many don’t file taxes.

That doesn’t mean, however, that they don’t pay taxes at all. Most of those who don’t pay federal income taxes pay payroll taxes through work. There are also state and local taxes, sales taxes and other taxes that capture revenue even from folks with very low incomes.

How to Reduce Your Tax Liability

If you’re not among the group with no income tax liability and you want to reduce your tax bill, what can you do? There are a few strategies.

Claim the right deductions: First off, it’s a good idea to make sure that you’re claiming all the deductions you’re eligible to claim. This is where tax preparation software (like TurboTax or H&R Block) or the service of an accountant can really come in handy, but it is possible to do it yourself.
Adjust your payroll exemptions: If you want to reduce your tax liability you can also adjust your payroll tax exemptions by filing a new W-4 with your employer. There are different schools of thought around this tax strategy, though. If you have too little withheld you’ll owe more at tax time. Nobody likes that feeling.
Donate to charity: Another popular method for reducing your tax liability is to donate to charity. Donations to qualified charities are tax-deductible. A tax deduction reduces your taxable income, which in turn reduces your tax liability. Giving away money or other assets is a great way to both lower your tax bill and support the causes close to your heart.
It’s important to obtain proper documentation for all of your donations. And of course, you can only deduct donations if you decide to itemize your deductions rather than taking the Standard Deduction. For many people, the Standard Deduction gives them a bigger tax break than they would get if they itemized, but your mileage may vary.
Contribute to a retirement account: One of our favorite way to reduce tax liability and prepare for your future is to save for retirement. Contributions to 401(k)s reduce your taxable income, as do contributions to deductible traditional IRAs. Contributions to Roth IRAs, however, are with post-tax dollars and do not reduce your tax liability in the year you contribute.

Deferred Tax Liability

Own a business? You may need to understand how deferred tax liability works. It stems from a “book-tax difference,” which is largely a difference of timing between financial accounting rules and IRS rules.

Take the 5-year depreciation of a business asset as an example of deferred tax liability. Accounting rules and IRS rules are different when it comes to depreciation. The difference between the tax expense (from financial accounting) and the tax payable (from IRS accounting) tells you whether you have a deferred tax liability or a deferred tax asset.

If in the future you will pay more to the IRS than the tax expense noted in your books, you have a deferred tax liability. This also happens if a business reports less taxable income than the income on its financial statements.

Your business has a deferred tax asset if less tax will be paid in the future than is due now. In other words, a deferred tax asset is the opposite of deferred tax liability. If a company reports more tax revenue than book revenue in the current period, it will “prepay” its taxes. That means less taxable income and taxes to pay in the future.

For example, the calculation for bad debt is different for financial accounting and tax purposes. This leads to higher taxes payable in the year of the debt and lower taxes in the future. That’s a deferred tax asset.

Tax Liability for Capital Gains

If you sell any asset, including real estate or other investments, for a gain then you’ll owe taxes on that gain. For example, if you buy a house for $500,000 and sell it 10 years later for $1,000,000 then your capital gains tax liability basis will be the $500,000 you sold the house for that is above the $500,000 you paid for it.

When an asset is held for more than a year, the transaction becomes a long-term capital gain. Long-term capital gains are taxed at a lower rate than short-term capital gains would be. However, both short-term and long-term capital losses are treated the same way when it comes to tax liability. Losses can be applied against long-term gains that were incurred during the same tax period. They can also be carried forward, in some cases, to future years.

Bottom Line

Whether you’re a business owner or an individual, figuring out your tax liability ahead of time will help you avoid surprises this tax season. The good news is that the IRS has extended the filing deadline for your 2020 returns by one month to May 17. Still, the unpredictable nature of taxes is one reason it’s important to keep an emergency fund. That way, if your tax liability varies from year to year you’ll have enough to cover the difference.

Tips for Understanding Your Taxes

A financial advisor can help you optimize your taxes for your investing and retirement goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Worried about comprehending your taxes? SmartAsset has you covered with a number of free online tax resources to help you manage your taxes. Go online to our website and check out our income tax calculator today.
If you don’t know whether you’re better off with the standard deduction versus itemized, you might want to read up on it and do some math. You might find that you’d save a significant amount of money one way or another, so it’s best to educate yourself before the tax return deadline.