What Are Tax Liabilities?
Your Tax Liability Appears on Line 63 of Your 1040 Tax Return
The word “liability” has a certain negative ring to it and with good reason. Technically, it means you’re responsible for something. Combine it with the word “tax” and you see where this is going. A tax liability is a tax debt you’re responsible for paying to the Internal Revenue Service or other taxing authority.
You can find yours for the year on line 63 of your Form 1040 tax return where it says, appropriately, "This is your total tax.”
Your total tax liability isn't necessarily for just one year, however. Anything that remains from previous years must be added to your liability for the current year, such as if you entered into an installment agreement to pay off last year’s tax debt and you haven’t made the last payment on that agreement yet. In other words, your tax liability is everything you owe the IRS at any given point in time.
It’s Not Just Income Tax
Tax liability isn’t just limited to any income tax you might owe. The term covers all forms of taxes, such as capital gains and self-employment tax, as well as interest and penalties. That installment agreement you entered into for last year’s taxes is payable with interest, so the interest is added to your total tax liability. If you took an early distribution from a retirement account that was subject to the 10 percent penalty, that’s included in your total tax liability, too.
Income Tax Rates
Income tax is the largest component of tax liability for most people, and it’s determined in part by the tax bracket they fall into—the percentage of their income that they must pay in taxes. This varies a fair bit because it depends on both filing status and how much you earn.
Consider this range: You’re single and you earn just $9,525 in 2018. This puts you in a 10 percent tax bracket so your income tax liability is $952. If you earn $80,000, this pushes you up into a 22 percent tax bracket on the portion of your income that exceeds $38,700. And if you’re married and you and your spouse jointly earn $200,000 a year? This bumps you into a 24 percent tax bracket for the portion of your income that exceeds $165,000.
Capital Gains Taxes
Capital gains tax can add to your tax liability if you sell an asset for more than your basis in it—what you paid for it plus certain allowable expenses. If you invest $5,000 in some stocks and turn around 18 months later and sell those same stocks for $7,500, you have a $2,500 long-term gain and this is taxed at special capital gains rates, either 0, 15, or 20 percent as of 2018 depending on your income. The more income you earn overall, the higher your capital gains tax rate.
If you owned the asset for less than a year, it's a short-term gain so it's added to your tax liability as ordinary income and according to your tax bracket.
The Power of Deductions
If this all sounds pretty dismal so far, you can relax a little. These factors are just the beginning of your tax liability. The tax code lets you whittle away at your taxable income with deductions.
The Tax Cuts and Jobs Act takes away the deduction for personal exemptions in 2018, which will hit some taxpayers hard. For the 2017 tax year, however, you can deduct a $4,050 exemption for yourself, one for your spouse if you're married, and one each of your dependents. That can really add up. Even with just one exemption for yourself because you're single, it would drop your taxable income from $80,000 to $75,950—and that's just one available deduction.
Unfortunately, the exemption goes away under the terms of the TCJA, at least from 2018 until 2025. But plenty of other deductions and tax credits remain intact.
The TCJA also adjusts tax brackets so you can earn more before you must begin paying a higher percentage, and the standard deduction has almost doubled. The 2018 standard deduction for a single taxpayer increases from $6,350 in 2017 to $12,000 in 2018.
Remember that $9,525 you made as a single taxpayer in 2017? Technically, your tax liability on that money would have been $9,525 less the $4,050 personal exemption, less the $6,350 standard deduction for that tax year. This leaves a negative balance so you would have had no tax liability. You still would not have a tax liability for that income in 2018 because $9,525 less the current $12,000 standard deduction also results in a negative balance.
The lesson here is that your tax liability is not based on what you earned in a given year. It’s based on what you earned less the personal exemptions in 2017 and less the standard deduction for your filing status or your itemized deductions if you decide to itemize instead. It’s based on what’s left after subtracting these figures, as well as any other deductions or tax credits you might be eligible for.
Don’t Forget Tax Credits
Tax credits reduce your tax liability, too, but in a somewhat different way.
Deductions subtract from your taxable income, but some credits subtract directly from your liability. Let's say you've done all the math and you’ve claimed every deduction available to you, and you still have a $5,000 tax liability on line 63. If you’re eligible to claim a $1,000 refundable tax credit, that liability drops to $4,000 because tax credits are treated as actual tax payments, just as if you had written the IRS a check for the amount.
That Number on Line 63
Yes, it sounds complicated, but if you take a look at Form 1040, you can clearly see how all this works out.
All your sources of income, including things like capital gains, are added up and reported on the first page of your tax return in the “Income” section. Then you get to make certain adjustments to that income in the next section, “Adjusted Gross Income.” This is where you might be able to claim some other deductions in addition to the standard deduction or itemized deductions to lower your taxable income.
Now your adjusted gross income or AGI is carried over to page 2 and a section titled “Taxes and Other Credits.” Some of these lines are add-ons that will actually increase your tax liability, such as the alternative minimum tax. But you’ll also find a space for the standard deduction or itemized deductions here, as well as spaces for a variety of nonrefundable tax credits you might be eligible for, all of which reduce your tax liability by reducing your taxable income. Your resulting taxable income appears on line 43.
Unfortunately, the next section, “Other Taxes,” involves addition, not subtraction, but many taxpayers dodge the bullets that are included here. If you’re self-employed, that tax appears in this section and will add to your tax liability, as do some other taxes and penalties that don’t affect all taxpayers.
And this brings you to line 63. But don’t gulp. You’re still not done yet.
Form 1040 includes yet another section for payments you’ve already made toward your tax liability. In most cases, this is accomplished through tax withholding from your paychecks. Your employer deducts a percentage from your pay according to the information you submitted to him on Form W-4 and he obligingly sends this money to the IRS on your behalf.
If you’re self-employed and you made estimated tax payments during the year, they're entered in this section as well. Refundable tax credits are included here, too. These credits don’t just subtract from your tax liability. The IRS will send you a refund for any balance left over if they reduce your liability to zero.
All these payments are subtracted from the number that appears on line 63—your tax liability. If this results in a negative balance—maybe your tax liability was $5,000 but total payments including refundable credits added up to $7,500—you can expect a refund from the IRS for the difference.
And if you don’t have a negative balance? If your liability was $5,000 but you only made $4,000 in total payments, including refundable credits, you still owe the IRS $1,000. This isn’t your tax liability—that remains at $5,000. It’s the amount of tax you still owe.