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Thursday, February 22, 2024

What is tax liability?

What is a tax liability?

07.20.2023

The average amount someone pays in federal income tax depends on a variety of factors, including how much they earned and what types of credits and deductions they qualify for. Anyone earning in the top 50% of the nation pays 14.82% or more of their income in federal taxes on average.1 This is a form of tax liability and can impact your overall financial picture.  

Definition of tax liability

In finance terms, a liability is a debt. It's an amount you are legally or contractually obligated to pay to another person, business or entity. A tax liability is an amount you have to pay to federal, state and local governments. 

Types of tax liability

Bring up the topic of tax liability and most people immediately think of income taxes. However, you can owe a variety of types of taxes depending on your lifestyle, where you live and what you own. Some of the most common tax liabilities are described below. 

Income tax liability

Income tax liabilities are those you pay based on the income you earned in the year. The types of income tax liability are:

  • Federal income taxes, which are paid to the Internal Revenue Service 
  • State income taxes, which are paid to the state government
  • Local income taxes, which are paid to county, city, or town governments

While everyone has to consider their potential federal income tax liability, not everyone pays state or local income taxes. If you live in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington or Wyoming, there is no state income tax.2 Many localities don't have income taxes, but in some areas, you might have to pay both county and city taxes.

Whether you have to pay federal income taxes depends on your income for the year. In some cases, you may not have to file an income tax return if you have no income tax liability.3 However, you may want to file a return even if you don't owe taxes, as this is the only way you can get any refund owed to you.

Sales tax liability

Sales tax is a liability that many consumers deal with on a regular basis. Only Delaware, Oregon, New Hampshire and Montana have no state sales tax4 and don't allow local sales taxes. Alaska doesn't have a statewide sales tax either, but it does allow local governments to set their own if desired. In any other state, you pay sales tax whenever you buy something.

Businesses that collect sales taxes from consumers then have a sales tax liability. They must report their revenues and sales tax figures to the appropriate local and state government and make a payment that covers the taxes collected.

Sometimes, you may make a purchase online and not pay sales tax on it. Your state might require that you track these purchases and report them at the end of the year, paying sales tax at that time.

Capital gains tax liability

Capital gains tax liabilities are owed on investment profits. You pay them for the tax year during which an investment was sold. For example, say you purchased stock in 2019 and held the stock until 2023. If you sell the stock for more than your original purchase price, you would owe taxes on the difference.

Capital gains taxes are calculated at different rates depending on the type of asset and how long you held it before selling it.

  • Short-term capital gains occur when you hold the asset for less than a year before you sell it. These are calculated as  ordinary income.
  • Long-term capital gains, on the other hand, are profits you earn on assets you’ve held for more than one year. The IRS looks at your taxable income for the year and your filing status to determine if your tax rate is 0%, 15%, or 20%.

Property tax liability

Property tax liabilities are paid based on property you own — most commonly real estate and vehicles, but some locations charge business property taxes that take into account equipment and inventory. Primarily, these taxes are paid to local entities, including counties, cities, towns, or school districts. The money collected from property taxes is often used to fund local infrastructure including education, emergency response, libraries and roads.

How much you paid in property taxes depends on factors including:

  • The property tax rate, which is typically a percentage 
  • The value of the property being taxed
  • Whether any exclusions or subsidies apply to reduce the amount you owe

What is deferred tax liability?

A deferred tax liability refers to a tax amount that is owed but doesn't have to be paid until a later date. 

Deferred tax liabilities are somewhat common in business accounting. The most common example of deferred tax liabilities for individuals has to do with retirement savings. When you make traditional 401(k) contributions, for example, you do so with pre-tax dollars. That means the amounts you put in those retirement savings aren't included in your taxable income for federal tax liability calculations at the end of the year. However, when you withdraw the money in the future, you have to pay taxes on it. Thus, the tax liability was deferred until a later date. 

How to calculate tax liability

Calculating tax liability can be complex. It can be a good idea to work with a financial professional to ensure your taxes are managed appropriately.

To calculate your property tax, you usually multiply the rate times the appraised value of the property. For example, in a location where the property tax rate is 2%, a property valued at $100,000 would result in a $2,000 tax bill. 

Income tax liability calculations typically require completing a federal, state or local return. The return process helps you understand how much you will owe. 

While many Americans pay taxes, the more income you make, the greater your tax liability might be. In fact, 97% of all income tax6 in the nation is paid by around half of the taxpayers. How much your federal income tax might be depends on which tax bracket you're in. 

How to reduce tax liability

You can reduce your tax liability in a number of ways. Some include:

  • Find out if you qualify for tax credits, which can reduce the amount you owe on income taxes or even result in a larger refund.
  • Ensure you're taking advantage of all applicable deductions, which reduce your taxable income and thus how much you might owe for income tax.
  • Research property tax exemptions and subsidies to help decrease how much your property tax liability might be.
  • Avoid short-term capital gains when possible by holding onto assets for longer than a year.

Taxes of all types are complicated, so working with a tax professional can help you find potential savings to reduce your tax liability without stepping over any legal lines. 

Our take 

Reducing your tax liability is just one way to save money. Making educated decisions about financial matters can help you create a solid foundation and build wealth for the future. If you’re looking for a better way to manage your money, consider Empower's free financial tools for monitoring all of your financial accounts in one place, monitoring your investments, and planning for your long-term financial goals.

The Currency editors

Staff contributors

The CurrencyTM, a publication from Empower, covers the latest financial news and views shaping how we live, work, and play. We keep you current on ways to plan, save, and invest for life.

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