How Do I Even Calculate My Tax Liability?

Only Two Things in Life that are Certain: Death and TAXES

Trust me, I understand. I might be an accountant, but that doesn’t mean that I love doing my own taxes. I usually still use an online tax software that asks me questions and spits out my total tax liability. Now, I will go back and check the work, but I am guessing for many of you, you have no idea how your taxes are calculated or why they even ask you certain questions. And why would you? You graduated high school, and maybe even college, without anyone ever explaining the tax system to you. Which is EXTREMELY frustrating to me, because it is something that we ALL have to pay into. Yet most of us do not understand how that magical number is created when we file our taxes.

I’m going to try to break it down into a few simple steps so that you can see a general overview of the process. This will help a lot when we go over the proposed changes, so you can see if it is an above the line deduction, a below the line, a credit, and what the hell is AMT anyways. Exactly. I want to acknowledge that this is a VERY simplified version of the tax calculation. So please do not attack me for not including every single number for phase outs or every deduction/credit known. I tried to make this relatively simple and include the major players. So let’s start from the beginning.

    1. Income – This one should be fairly obvious. This is all of the money that you made during the year. This includes anything on your W2 (if you have a job that gives you one), maybe it is a 1099 (for those who are contractors), and it could be rental income, investment income, or even winnings from that day that you were killing it at the casino. You have to figure out exactly how much you brought in this year. Common items that are included in your total income include:
      • Wages, salaries, tips
      • Taxable Interest (tax-exempt is listed but not included)
      • Ordinary Dividends (Qualified are listed as well)
      • Taxable Refunds, credits, etc.
      • Alimony received
      • Business income
      • Gains and losses
      • Distributions from an IRA or pension/annuity
      • Rental income
      • Unemployment compensation (different from workers compensation)
      • Taxable amount of Social Security
    2. Before AGI Deductions (also known as Above the Line Deductions) – So, first off, AGI stands for Adjusted Gross Income. This is how much money you made after certain deductions. The following items are common items that you get to deduct from your Total Income to get to your AGI:
      • Educator expenses
      • Certain business expenses
      • Health Savings Account (HSA)
      • Qualified moving expenses
      • Self-employment tax
      • Self-employment SEP, SIMPLE plans
      • Self-employed health insurance
      • Penalties on early withdrawal of savings
      • Alimony paid
      • IRA deduction
      • Student loan deduction
      • Tuition and fees
      • Domestic production activities
    3. AGI – Adjusted Gross Income – It is important to remember this item, as it can affect certain items if you itemize your taxes. As with most things when doing your taxes, we want to get this number as low as possible.
    4. Standard vs Itemized: Now comes the question, do you take the standard deduction or do you go through the math of itemizing. While some people claim the standard because they either do not want to go through the hassle of itemizing or they do not want to get all of the supporting documents, it can be beneficial to calculate your itemized deduction to see if it is more than your standard. It should be noted that there are some phase-out limits that might prevent you from itemizing that are based on your AGI, but they are rather high and do not affect the majority of filers. I will go into the details of what the current rules are for standard deductions and itemized deductions further down in this article when I compare them for changes. Here are some of the itemized deductions that people use now:
      • Medical and dental expenses
      • State and local taxes
      • Real estate taxes
      • Personal property taxes
      • Home mortgage interest
      • Mortgage insurance premiums
      • Gifts to charity
      • Casualty and theft losses
      • Unreimbursed employee expenses
      • Tax preparation fees
    5. Personal Exemptions: You are entitled to take the personal exemption for yourself, your spouse, and any dependents. In 2017, this is $4,050 per person.
    6. Taxable Income: Now that you have taken out your above the line deductions, your standard/itemized deductions, and personal exemption, you have arrived at your taxable income. This is the amount that you take to the tax brackets to calculate how much tax you actually owe the IRS.
    7. Tax Liability: This is the amount that you actually owe the IRS.
    8. Alternative Minimum Tax (AMT): This is basically where you do a separate tax calculation to see whether or not you need to pay more taxes. Essentially, calculating your AMT forces you to add back certain deductions. If your AMT is higher than your original tax calculation, you have to pay the higher amount. This was essentially created to prevent wealthy taxpayers from using too many loopholes to avoid paying taxes.
    9. Tax Credits: These are items that actually reduce your tax liability (what you owe the IRS), instead of a deduction (which only lowers your taxable income that is used to calculate your tax liability). People like tax credits better for this reason. Popular ones include:
      • Foreign tax
      • Earned income tax
      • Child and dependent care expenses
      • Education (American Opportunity and Lifetime Learning)
      • Retirement savings contributions
      • Child tax
      • Residential energy
      • Adoption
      • Elderly/Disabled
    10. Payments: This is where you are entering in what you have already paid in taxes, whether it was through your paycheck or you mailed in quarterly payments. This is what is going to be matched up against your tax liability.
    11. Refund: Everyone’s favorite word that is associated with taxes. It’s because this implies that you paid too much and now you get some money back. However, sometimes you actually owe more money because you received income over the year that you didn’t pay tax on. Regardless, this is where it gets real. Either you start planning a trip in your head or you start calculating all of the overtime that you need to work.

Okay, we survived. We actually got through the steps of calculating your taxes. Now that you’re basically a human version of Turbo Tax, let’s see what the proposed changes are and how they could affect you based on what deductions/credits you use.

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About Dave 12 Articles
I'm the Common Cents Millennial and I am here to change how you think about your finances. Follow me as I struggle with student debt, side hustling, budgeting, lowering my expenses, and my path to early retirement. My goal is to go from $150k in student debt to early retirement in 15 years or less!

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