Making sense out of how tax liability is determined.
When I was young, one of the hardest concepts for me to understand was how it was determined how much tax I owe. I’ll try here to unravel one of the worlds mysteries.
We start with the Tax Payer’s gross income (both spouses if married filed jointly). This includes wages, tips, interest income, capital gains – basically anywhere money was put into your pocket. Next, we take all adjustments to income we are entitled to. This becomes your “Adjusted Gross Income” or AGI. After we have our AGI, we deduct our standard or itemized deductions to get to our “Taxable Income” In many cases, the amount of deduction is governed by our filing status.
Once we get our taxable income, we can then go to the tax tables to determine the amount of our Tax Liability. We’ll cover tax tables in a future blog. At this point, most people will get some sort of tax credits. Some of these could be Earned Income Tax Credit (EITC) or Child Tax Credit (CTC). There are others and you should consult your tax professional to see what you might qualify for. The result is the amount of tax we would owe for the year.
Lastly, we look at how much Federal Income Tax has been withheld throughout the year. This is shown on W2 and 1099 forms. For self-employed this would include estimated tax payments. If the amount paid is smaller than the amount owed, then we would have to pay the difference. But if the amount paid is larger than the amount owed, we get a refund of the excess.