Federal Income Tax Liability: Everything You Need to Know
Federal income tax liability is the amount of tax you owe to the federal government on your annual earned income.3 min read
2. Components of Federal Income Tax Liability
3. Capital Gains Tax
4. Strategies to Reduce Tax Liability
5. Deferred Tax Liability
6. Calculating Federal Income Tax Liability
Federal income tax liability is the amount of tax you owe to the federal government on your annual earned income. Depending on your income, you may or may not owe federal taxes; those whose income is lower than the standard deduction do not owe income tax.
Taxation and Tax Liability
The tax liability for an individual or business is calculated based on current tax laws. This involves multiplying the tax base by the tax rate. Income that is subject to federal income tax includes earnings, gains on sales of a home or other asset, and other taxable events. This income may also be subject to state and local taxes.
The tax liability amount calculated above is reduced by items such as deductions, credits, and estimated tax payments made to reach total tax liability. If this is unpaid, charges, fees, and interest accrue over time.
Components of Federal Income Tax Liability
Federal income tax liability is made up of three main components:
- Principal tax is the base amount on which interest is calculated. This amount comes from original and substitute balances along with additional assessments.
- The original balance is the number shown in the balance due section of a prepared tax return.
- A substitute balance is the liability amount determined by an IRS-prepared return, using either past taxpayer information or third-party information.
- Additional tax assessments such as balances derived from error correction or audit.
- Penalties are the fees you are charged for failing to pay and file your taxes in accordance with IRS regulations. Penalties are typically a percentage of the total owed, so if your balance is zero you may not be penalized. However, some types of businesses are subject to a late-payment penalty even if they do not owe taxes. The most common types of penalties are:
- Failure to file
- Late payment
- The IRS also assesses interest as a fee on your past-due balance, even if you are enrolled in a payment plan. The interest is calculated not just on the principal tax, but also on accrued interest and penalties.
Other aspects of federal tax liability may include household employment tax, self-employment tax, and penalties such as those for lack of health insurance coverage or the IRA early distribution penalty.
Capital Gains Tax
Capital gains, such as the sales of real estate, an investment, or other asset, are subject to additional federal income tax liability on the profit amount. For example, if you purchase a property for $100,000 and sell it for $150,000, capital gains tax is assessed on the $50,000 profit. The capital gains tax rate varies and may be different than the income tax rate.
Strategies to Reduce Tax Liability
Careful planning can help reduce your income tax liability. First, make sure you're claiming all the deductions for which you qualify. You can also file a new W-4 with your employer to adjust payroll tax exemption. Withholding more money means you will owe less at tax time.
Donations to charity can be deducted from your taxable income, which lowers your tax liability. It's important to document these donations correctly to ensure they can be deducted.
Deferred Tax Liability
Some types of businesses are affected by deferred tax liability, which occurs because of the discrepancy between IRS and financial accounting rules. One common type of deferred tax liability is five-year business asset depreciation. The IRS treats depreciation differently than the accounting profession does. Subtract the tax expense, using the financial accounting method, by tax payable according to the IRS accounting method, to find either the deferred tax liability or deferred tax asset.
Calculating Federal Income Tax Liability
First, find your gross taxable income for the tax year in question. This amount must include salaried wages, bonuses, tips, alimony payments, commissions, income from a hobby or side business, capital gains income, interest, retirement fund distributions, unemployment payments, and state and local tax refunds.
Some types of income are not taxed, including federal tax refunds, inheritances, gifts, welfare payments, child support payments, proceeds from life insurance policies, and tax-exempt bond interest.
Then, find your adjusted gross income by making common adjustments such as IRA contributions, alimony payments, student loan interest, moving expenses, tuition payments, and medical insurance premiums.
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