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Taming the Tax Beast: How Do I Calculate My Tax Liability:Figuring Out My Income Tax Liability - We're going to talk about income tax liability. No, please, stay. It's really not that bad. Income taxes tend to cause headaches, anxiety, fatigue, anger, sadness, joy, excitement. But whatever feelings they evoke in you, it remains that they have to be dealt with before April 15 every year. You don't want to end up like Wesley Snipes, who is serving a three-year prison sentence for tax evasion! Prison is no fun, even when compared to doing your taxes. The problem that many of us non-accountants have with taxes is that they are complex. There are terms and formulas that appear arbitrary. Flat taxes suddenly seem like a great idea. But once you know the terminology and the method behind tax madness, you can get a grip on your own tax returns. So, what is income tax liability and how do you calculate yours?
What is Income Tax Liability?:It sounds pretty serious, whatever it is. Liability is not usually a word you really want to get to know that well. According to Investopedia, tax liability is the "total amount of tax an entity is legally obligated to pay to an authority as a result of the occurrence of a taxable event." In this case, you are the entity, and the taxable event is your income from employment. Taxable events can also be the sale of an asset or an investment. Say you won the lottery: congratulations! That's a taxable event. All this means is that you have to pay the government a tax on any money that you earn, accrue, win, or inherit. Failing to do so may mean you'll be bunking with Wesley Snipes. More likely, though, the following would happen:
*Penalties and interest are assessed. The IRS or state tacks this on to your debt. The penalties can be 25 percent of your unpaid taxes, and interest can be four to ten percent. In the US, 47 percent of people typically do not have to pay taxes. If you are one of the remaining 53 percent, it is best to pay your debt as soon as possible to avoid serious consequences.
How Do You Calculate Your Income Tax Liability:Taxes can get complicated as you add in various forms of income, dependents, credits, deductions...you can feel that headache coming on, can't you? First, make sure you have all the paperwork that you need, such as the IRS forms, 1040, and your W-2 or 1099 forms. Accountants can help you with this, and online services, such as Turbo Tax and Tax Act, make it much easier as they guide you through step by step. After you have your forms, add up your income from wages, salary, and tips, the income from unemployment compensation, the income from self-employment, and whatever else you have earned. The next step is to calculate your deductions. You can deduct things like your student loan interest, IRA contributions, or expenses incurred from self-employment (be careful about the latter. Some say the IRS flags self-employed people who claim home office deductions. Make sure you have receipts to back up your claims). There are a lot of possible deductions, so make sure to read through the forms carefully so you get each one you are entitled to. Once you have calculated this amount, subtract the deductions ("above the line" deductions, listed in lines 23 - 35) from your total income. The result is your adjusted gross income. You're making progress now. Next up, you calculate allowable deductions. These are itemized deductions which you fill out on Schedule A of the 1040 form. They can include state and local taxes, interest on your mortgage, medical expenses, and more. Once you get this amount, look at your standard deduction. Choose the larger of the deductions (which, for most people, is the standard deduction). Subtract this from your adjusted gross income. Almost there. Next, calculate your taxable income. Take the number of dependents (from line 6) and multiply it by $3650 (this figure is for 2010, but it may change. Whatever the case, the figure will be listed on your tax form). This is your exemption. Subtract this from the value from your last calculation. Finally, you calculate your total tax. You will need to multiply your taxable income by your applicable tax rate (which is found in the 1040 instructions). It is easy to get lost in taxes. If you are reading this and thinking, "What? Taxable, adjusted what?", you are not alone. Let's plug in some numbers so it makes more sense. All of the forms and tables are available online or from the IRS website (IRS.gov). Say you have income of $35,000. These are your wages as reported on your W-2, which your employer sends out to you in January. This is your income on line 22. Next are your deductions. Say you have paid $250 in student loan interest. You subtract $250 from $35,000. $34,750 is your adjustable gross income. Now your itemized deductions, which can include things like gifts to charity. If you think you have a lot of these deductions, fill out Schedule A. Then check to see if that number is bigger than the standard deduction. In 2010, the standard deduction for a single filer is $5700. Let's say the standard is bigger. We subtract $5700 from our adjusted gross income of $34,750. This is $29,050. Ok, now say you have two dependents (line 6). Multiply 2 x $3650. This is $7300. We subtract this from $29,050 to get $21,750. This is our taxable income. Now, we multiply this by the applicable tax rate. In our example, you are single, so your tax is $2848. This doesn't mean you have to pay $2848. In fact, you may still get a refund. You have to subtract payments, for things like income tax withheld, first time homebuyer's credit, or Earned Income Tax Credit. If you paid more than your tax rate, you are refunded the difference. If you paid less, then you owe the difference. Taxes aren't as scary as they seem. When you can go step-by-step, you can break down the information and keep plugging in the correct numbers. It can be confusing, but again, those online programs like Turbo Tax can help guide you through the process. They even do the math for you. Whether you do paper returns (which are slowly being phased out), go online, or have a tax service take care of your taxes, the important thing is you pay the government the money it is owed - or much better, the government pays you the money you are owed.
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