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Some ways to reduce your tax liability include contributing to a retirement or health savings account<\/a>. You can also use credits or other deductions to reduce your taxable income.<\/span><\/p>" } } ] } ] } ]

Tax Liability: Definition, Calculation, and Example

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Updated September 10, 2025
Reviewed by Margaret James
Fact checked by Kirsten Rohrs Schmitt

What Is Tax Liability?

A federal tax liability is an amount that’s owed to the government in taxes. It can include income taxes on earnings and capital gains taxes on assets. Both are based on brackets, a percentage of the money earned, and brackets are determined by various factors.

A liability can be owed by an individual, business, or other entity. It can be owed to a state or local tax authority as well as to the federal government.

You generally have a tax liability when you earn income or generate profits by selling an investment or other asset. It’s possible to have no tax liability if you don’t meet the income requirements or brackets to file taxes.

Key Takeaways

  • Tax liability is the amount of tax debt owed to a government by an individual, corporation, or other entity.
  • Income taxes, sales tax, and capital gains tax are all forms of tax liabilities.
  • Taxes are imposed by various taxing authorities, including federal, state, and local governments.
  • Taxes generate the funds necessary to pay for services such as repairing roads and maintaining a military.
  • You can lower your tax liabilities by claiming deductions, exemptions, and tax credits.
Tax Liability: Money owed to tax authorities.

NoNo Flores / Investopedia

Understanding Tax Liability

Federal, state, and local governments impose taxes and use the money that’s raised to pay for services such as repairing roads, funding social programs, and maintaining a military.

Companies withhold income taxes, Social Security taxes, and Medicare taxes from employees’ wages and send the money to the federal government to cover their tax liabilities.

Important

Social Security and Medicare are taxed at a flat rate that’s more or less applicable to all taxpayers, but U.S. federal income tax rates are progressive. A higher income will put you in a higher tax bracket on your top-earned dollars. The percentage owed for taxes and your federal tax liability will become greater if you earn more.

Your tax liability doesn’t just include your income and earnings in the current year. It factors in any past years for which taxes are owed. Any unpaid taxes from previous years are also added to your federal tax liability if back taxes are due.

How to Calculate Your Tax Liability

The most common federal tax liability for Americans is the tax on earned income. Each year, the Internal Revenue Service (IRS) announces the tax brackets and standard deductions for the following tax year.

The standard deduction is subtracted from your total income, and you’re only taxed on the remaining balance. The amount you can deduct depends on your filing status. You also have the option of itemizing your deductions instead of claiming the standard deduction, but you can’t do both. Many filers find that their standard deductions are larger than the amount of itemized deductions they’re eligible to claim.

Tax bracket income ranges are adjusted annually to keep pace with inflation. The income tax brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Hypothetical Example of Tax Liability Calculation

Some taxpayers mistakenly believe that their income tax is the same percentage as their income tax bracket. This is incorrect; each tax rate applies only to income in that bracket, after deductions have been applied.

Here's a hypothetical example, using simple numbers. Imagine if the tax brackets are published as follows. This is just for demonstration purposes, as the actual tax brackets are adjusted every year. They are also different depending on your filing status:

Sample Table of Income Tax Thresholds
 Tax Rate  Income Thresholds (hypothetical) What You Pay
 10% $0-$10,000 Pay 10% of your first $10,000 of income.
 12%  $10,000-$50,000  Pay 12% on any income between $10,000 and $50,000.
 22% $50,000-$100,000   Pay 22% on any additional income up to $100,000
 24%  $100,000-$190,000  Pay 24% of any additional income up to $190,000
 32%  $190,000-$250,000 Pay 32% of any additional income up to $250,000
35% $250,000-$600,000 Pay 35% of additional income up to $600,000.
 37%  $600,000  Pay 37% of every dollar above $600,000.

Suppose that a taxpayer earns $200,000 in a given tax year. That doesn't mean that they pay $64,000, or 32% of their income, in taxes. Here's how they would calculate their tax liability.

First, they would subtract deductions. Let's say that the standard deduction is $25,000 (in real life, this also changes every year) and the taxpayer has not contributed to any retirement accounts. If they take the standard deduction, that reduces their adjusted gross income to $175,000, reducing their tax bracket to 24%.

But that's still not the tax rate that applies to their entire income. Instead, the taxpayer would pay:

  • 10% of the first $10,000: $1,000
  • 12% of any income from $10,000-$50,000: 12% X $40,000 = $4,800
  • 22% of any income from $50,000 to $100,000: 12% X $50,000: $6,000
  • 24% of any income from $100,000 to $190,000: 22% X $75,000 = $18,000

In this hypothetical example, the taxpayer would owe $28,800 in income tax, or 14.4% of their total income. This example does not include other taxes, credits, or adjustments.

Liability or Refund?

Suppose you're earning $130,000 per year, and you have a federal tax liability of $20,738. If your employer only withheld $17,000 on your paychecks, you would owe an additional $3,738 in taxes: $20,738 - $17,000 = $3,738.

But if your tax withholdings were greater than your final tax bill, the IRS would send you a refund for the difference.

Fast Fact

Locate your state’s standard deductions and tax information and use the instructions provided by the state to calculate your state liability. Some states have a single tax rate, others have graduated brackets like the federal government, and some have no income tax at all.

How Capital Gains Are Taxed

You’ll owe taxes on the gain when you sell an investment, real estate, or any other asset for a gain. You can report it as a capital loss if you sell it for a loss. Capital gains are taxed in two ways. They’re either long-term or short-term. It’s a short-term capital gain if you hold an asset for one year or less before selling it for a gain. It’s considered a long-term capital gain and is subject to the capital gains tax if you hold it for more than one year before selling it for a gain.

Short-term capital gains are taxed at the same rate as your ordinary income. Long-term capital gains are taxed at a rate of 0%, 15%, or 20%, depending on your taxable income. Just like for ordinary income tax, the thresholds for these tax brackets change according to inflation.

Assume you purchase 100 shares of XYZ common stock for $10,000 in 2019. You sell them five years later in 2024 for $18,000. The $8,000 gain is a taxable event. You held the stock for more than one year, so the gain is a long-term capital gain.

If you had sold the shares after holding them for one year or less, the $8,000 gain would be considered a short-term capital gain and taxed as ordinary income, increasing your taxable income for the year.

How to Reduce Your Tax Liability

Taxes can take a significant bite out of your take-home pay, but it’s something everyone has to live with. However, you can reduce the amount of taxes you pay in several ways.

Deductions and Credits

You might qualify for other deductions or credits. Deductions reduce your taxable income and credits reduce the amount of tax you owe. Some deductions you might be able to claim include:

  • Business expenses
  • Using your car for business purposes
  • Using your home for business purposes
  • Itemized deductions
  • Education deductions
  • Healthcare and health insurance deductions
  • Investment deductions

Some available tax credits include:

  • Family and dependent credits
  • Income and savings credits
  • Homeowner credits
  • Healthcare credits
  • Education credits

Contribute to a Retirement Fund

Contributing to a retirement fund does more than help you save for and grow your retirement nest egg. You can reduce your federal tax liability for years to come if you plan carefully. You can contribute a specific amount per year to your traditional individual retirement account (IRA), and this amount is tax deferred. You can contribute to a Roth IRA after you’ve paid taxes on that money.

Determine how much you believe you’ll be taxed in retirement by projecting your income and withdrawals to lower your tax liability by contributing. A traditional IRA can lower your total tax payments if you’re in a higher tax bracket now that you will be in retirement because:

  • Taxes are deferred to your retirement years.
  • You’ll be in a lower bracket with less tax liability at that time.

A Roth IRA can lower your total tax payments if you’re sure you’ll be in a higher tax bracket after you retire and begin taking withdrawals, because those withdrawals will be tax free.

How Is Tax Liability Determined?

You can determine your federal tax liability by subtracting your standard deduction from your taxable income and referring to the appropriate IRS tax brackets. The IRS provides an estimating tool on its website.

How Do I Know If I Have No Tax Liability?

You have no tax liability if you aren’t required to file an income tax return or have no taxable income for the tax year.

How Do I Reduce My Tax Liability?

Some ways to reduce your tax liability include contributing to a retirement or health savings account. You can also use credits or other deductions to reduce your taxable income.

The Bottom Line

Your federal tax liability is the amount of taxes you’ll owe on your taxable income for the year. You’ll have some tax liability if you earn income.

Add all your income and subtract your standard deduction to figure out your taxable income. Then refer to the IRS tax brackets to find your tax liability. You might speak to a tax professional if the amount is more than you think you can handle, and the IRS offers a variety of payment plans if you’re really in a jam.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

  1. Internal Revenue Service. “Credits and Deductions for Individuals.”

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