Content of the material
- Definition and Examples of Tax Liability
- How to Reduce Your Tax Liability
- Can You Claim Exempt for One Paycheck?
- What Happens if I File as Exempt When I’m Not Eligible?
- Is Filing as Exempt Illegal?
- Types of Tax Liability
- W-4 Exempt Status Help
- What Does It Mean to Be Exempt From Federal Tax Withholding?
- Why Its Important to Know Your Tax Liability
- Understanding Tax Liability
- Tax liability example
- The State of the Tax Code
- Final Thoughts
- Need a Loan? Get One in 3 Simple Steps
Definition and Examples of Tax Liability
Your federal tax liability is the amount of money you owe to the U.S. government in a given year, based on the rules set by the Internal Revenue Service (IRS). Filing your income tax return will lead you to find your tax liability for the prior year. Anything that remains unpaid from previous years should be added to what you owe in the current year to ascertain your total tax liability. It’s included in your tax liability if you entered into an installment agreement with the IRS to pay off last year’s tax debt, and you haven’t yet made the final payment on that agreement.
You can find your tax liability for the year on lines 37 and 38 of IRS Form 1040. Appropriately, line 37 says, "Amount you owe.” Line 38 is dedicated to any penalty you might owe for making your estimated tax payments late.
Two lines on Form 1040 actually refer to your tax liability. Line 37 tells you the total tax you owe for the year, and then line 38 shows any estimated tax penalty you might owe.
Technically, line 24 is your total liability for the tax year, but the IRS probably already has some of that money, either through tax withholding from your paychecks or because you've made quarterly estimated payments. It's line 37 that you have to concern yourself with, because the IRS still wants that balance.
Payments you've already made to the IRS appear on line 33. The difference between this and line 24 will either appear on line 34 as an overpayment—indicating that you'll be receiving a refund—or on line 37 as a balance you still owe.
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.
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.
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.
On the one hand, you will have more money in your paycheck throughout the year and you can put that money to work for you by investing it. On the other hand, if you have more withheld from your payroll taxes you’ll reduce your tax liability, but the government will be earning the interest on that money throughout the year, not you.
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.
Here at SmartAsset, 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.
Can You Claim Exempt for One Paycheck?
If you want to temporarily stop tax withholding from your paycheck, you’ll need to file a new Form W-4 with your employer.
What Happens if I File as Exempt When I’m Not Eligible?
Filing for exemption from withholding won’t cause you to pay any less in taxes. If you owe taxes but file as exempt, you’ll have to pay the full tax bill when you file your taxes next year. Not only that, but the IRS can charge you additional penalties for failing to withhold.
If you’re confused about whether you can file for an exemption from withholding or have other questions about your tax status, you should consult an experienced tax professional.
Is Filing as Exempt Illegal?
Filing as “exempt” is not illegal. If you meet the criteria for filing as exempt you should file exempt on your W-4. Even if you qualify for a federal tax exemption, your employer will still withhold Social Security and Medicare taxes.
The reason you are cautioned against filing as exempt is not that it is illegal, but because you can get into trouble with the IRS if you do it when you do not qualify. If you should be paying tax, your employer should be withholding this from your paycheck for you. If you withhold too little, you are not making your tax payments to the IRS. You may then owe tax and face a penalty when you file your return.
Types of Tax Liability
Tax liability isn’t limited to the income tax you might owe. Technically, the term covers all forms of taxes, such as capital gains and self-employment tax, as well as interest and penalties. Other factors include the following:
- Interest is added to your total tax liability if you entered into an installment agreement with the IRS to pay a previous year’s taxes.
- An early distribution from a retirement account that was subject to the 10% penalty would be included in your total tax liability as well.
- Capital gains tax can add to your tax liability if you sell an asset for more than your basis in it. Your basis is the amount of your investment in the asset. Long-term gains are taxed at special capital gains rates: 0%, 15%, or 20%, depending on your income (with some rare exceptions). It's a short-term gain if you owned the asset for one year or less, and it would be added to your tax liability as ordinary income and taxed according to your tax bracket.
W-4 Exempt Status Help
Improperly claiming exempt from federal tax withholding can have major consequences. So, as you complete your Form W-4, make sure to do it with care – and be sure about if you can file a W-4 claiming exempt status.
If you’re seeking more assistance when it comes to claiming an exemption from withholding federal taxes, check out our W-4 Withholding Calculator. For personalized assistance, find a tax office nearest you!
What Does It Mean to Be Exempt From Federal Tax Withholding?
When you file as exempt from federal withholding, the government will stop withholding federal income taxes from your paychecks. However, you can’t claim exempt status just because you feel like it. You can only file as exempt for the tax year if both of the following are true:
- You owed no federal income taxes the previous year; and
- You expect to owe no federal income taxes for the current year
Keep in mind that just because the government sent you a refund check last year, it doesn’t mean you didn’t owe any taxes. A refund just means the government took more in withholding than you owed. Not owing any taxes is different — it means the total tax you owed according to IRS Form 1040 was completely taken care of by tax credits and deductions. If that was the case last year and you expect it to happen again this year, you might qualify for exemption from federal withholding.
RELATED: Income Tax Payment Options Explained
Why Its Important to Know Your Tax Liability
Your first day of work at a new job is usually a blur of new names and faces, but at some point you probably filled out a W-4 form. This form determines how much money your employer withholds from your paycheck to send to the IRS to cover your tax liability.
If you’re wondering how much you pay in taxes, take a look at your pay stub. (It’s that slip of paper you toss in the trash before cashing your check . . . or that form you ignore in your online payroll system.) Seriously, though, it’s a good idea to look at your pay stubs from time to time just to make sure your withholdings are okay.
When tax season hits, if your paycheck withholdings are less than your total tax liability, you’ll have to cut Uncle Sam a check for the difference. Boo! If your withholdings are higher than your total tax liability, then you’ll get a refund. Yay! Well, don’t do a tax refund happy dance just yet.
At the end of the year, you really don’t want to pay extra taxes or get a big refund. A refund means you overpaid Uncle Sam for a whole year. Wouldn’t you rather keep that extra money in your pocket?
And this is why knowing your tax liability is important. If you adjust your tax withholdings to match your total tax liability, you can get your refund as close to zero as possible. Changing your withholdings could feel like getting a raise!
If you had to pay the IRS at the end of the year or got a big refund, talk to your employer about adjusting your W-4. You want to make sure you have just enough taxes taken out of your paycheck to keep Uncle Sam happy.
If you’re self-employed or own a small business, things are a little more complicated. You’ll have to estimate your tax liability and make quarterly tax payments throughout the year. But the goal is the same: Don’t overpay or underpay the IRS.
Understanding Tax Liability
Taxes are imposed by a variety of authorities including federal, state, and local governments, which use the funds to pay for services such as repairing roads and defending the country.
Sales tax and company payrolls are forms of tax liability. When businesses sell their products, many states and some local governments charge a sales tax, which is a percentage of each sale and is paid by customers. Businesses send the sales taxes they collect to taxing authorities monthly or quarterly. Companies withhold income taxes and taxes for Social Security and Medicare from employees' wages and send them to the federal government immediately.
An individual’s or corporation’s tax liability doesn’t just include the current year. It factors in any and all years for which taxes are owed. That means that if there are back taxes (any taxes that remain unpaid from previous years) due, those are added to the tax liability as well.
Tax liability example
Taxes on earned income are the most common type of tax liability. Franz earns $50,000 in gross income, reported on a W-2 form to the Internal Revenue Service (IRS). At a federal tax rate of 20 percent, the income tax liability of Franz’s salary is $10,000.
On his W-4 filing, Franz’s employer withheld $8,000 in federal taxes, and Franz made a $1,000 tax payment during the year. When he files his Form 1040 individual tax return, the remaining tax payment due is $1,000. Alternatively, if Franz’s employer only withheld $5,000 and he made no additional payments, Franz now owes the IRS $5,000.
The State of the Tax Code
Tax code is complicated. However, the basic framework is simple. Your tax rate gets progressively higher as your income increases. The complexity arises from the various types of income as well as deductions and credits available to taxpayers that plan carefully.
Another layer of complexity arises when these deductions and credits phase out as incomes increase. The tax system is so complex for many reasons, from individuals who take advantage of loopholes in the code (prompting the creation of further rules), to government-driven initiatives and incentives. And the sweeping tax code changes that resulted from President Donald Trump’s 2017 Tax Reform and Jobs Act make things even more confusing.
Hopefully, these guidelines can help you determine are you exempt from federal withholding.
If you earn less than the income tax thresholds laid out by the IRS, you do not owe any tax. If you do not owe any tax, your employer should not withhold money from your paycheck to pay the IRS on your behalf.
You can stop this withholding by filing for an exemption from withholding on your W-4. It is not illegal to file as exempt if you are eligible. If you lie about your eligibility or taxable income, you can expect a large tax bill and possible penalties from the IRS.
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