Income Tax Brackets Explained: How to Calculate Your Net Tax Liability

Executive summary

As a tax preparer and financial planner, I get asked a lot of tax questions from clients when reviewing their tax return or looking at a tax projection. However, two of the more frequently asked questions are:

Can you explain (in a few steps) how my tax refund (or amount owed) was calculated? And,

How do income tax brackets work?

So, in today’s blog we are going to dive into these questions. The main takeaways are:

1) Determining whether you are entitled to a tax refund can be broken down into ten steps.

2) Deductions and credits help reduce your taxable income and tax liability respectively.

3) Different tax rates apply to different ranges of taxable income.

how to calculate your refund (or amount owed)

Let's start with a very high overview of the steps involved to calculate whether you are receiving a refund, or if you owe the government money.

Step 1: Determine your gross income, which for many people contain wages, bonuses, or other compensation from your job, profit from a rental property, the gain from selling an investment, interest from a bank account, or retirement plan withdrawals, just to name a few examples.

Step 2: Look at your eligibility for any "above-the-line" deductions. A few of the more common "above-the-line" deductions include: IRA contributions, the interest paid on student loan payments, and contributions made to a health savings account.

Step 3: Calculate Adjusted Gross Income, or AGI, which is your gross income after subtracting any above-the-line deductions. AGI is a very important tax number because AGI, or some variation of AGI, is used to determine your eligibility for certain tax credits and deductions. It's also used to determine your ability to contribute to an IRA or Roth IRA, and if you are of Medicare age, AGI is used to calculate your Medicare premium.

Step 4: Once your AGI is calculated, we go through another round of deductions and take the larger of either a: your itemized deductions, or b: the standard deduction, which is a predetermined amount depending on your tax filing status.

There is one additional deduction called the Qualified Business Income Deduction that some taxpayers are eligible to use, however only certain types of business income and real estate dividends are eligible for this deduction. If you find that you are eligible for this deduction, then it too gets subtracted from your AGI.

Step 5: Calculate your taxable income, which is your AGI - (itemized deductions/standard deduction + QBI deduction).

Step 6: Calculate your gross tax liability by using the various tax brackets and applying those to your taxable income.

Step 7: Determine your eligibility for various tax credits. Tax credits are a dollar-for-dollar reduction in your tax liability. So, they are even better than tax deductions, which saves you less than a dollar in tax liability for every dollar of deduction.

Step 8: Calculate your net tax liability (gross tax liability - tax credits).

Step 9: Sum any tax withholding or other tax payments that you made throughout the year.

Step 10 (Final Step): Subtract your payments from your net tax liability. The result will determine whether you are entitled to a refund, and if so, how much of a refund. You are entitled to a refund if your payments EXCEED your net tax liability. Otherwise, you owe the IRS and that payment is due by April 15th. If not paid by the 15th then you will start accumulating interest on top of the amount owed.

how to income tax brackets work?

Okay, now that we've discussed the process of determining whether your entitled to a tax refund or not, let's now talk about how income tax brackets work.

As the chart shows, there are seven brackets and each bracket correlates to a specified range of taxable income. For instance, if you are married and filing a joint tax return, then your taxable income between $96,951 and $206,700 is taxed at a rate of 22%.

I find that using an example with hypothetical numbers is best for explaining how income tax brackets. With that said, let's look at a tax projection for a married couple filing a joint return with taxable ordinary income of $172,500.

We start by calculating the tax liability from the 10%. For a married filing joint return, the first $23,850 of taxable income is subject to a tax rate of 10%. Therefore, the tax liability is $2,385 (10% of $23,850).

Next, we move to the 12% bracket. This bracket starts at $23,851 of taxable income and ends when taxable income reaches $96,950. Similar to the 10% bracket, we now calculate the tax liability for the taxable income in the 12% bracket. That calculation is $96,950 (upper limit) - $23,851 (lower limit) multiplied by the tax rate of 12%. This equation yields a result of $8,772.

We continue on to the 22% bracket, which runs from $96,951 of taxable income to $206,700 of taxable income. This couple does not have $206,700 of taxable income so our calculation becomes $172,500 (taxable income) - $96,951 (lower limit of the 22% bracket) multiplied by the tax rate of 22%. This yields a tax liability of $16,621.

The last step is to add the tax liabilities of the 10%, 12%, and 22% brackets. So, $2,385 + $8,772 + $16,621 equals $27,778 and that represents their gross tax liability on $172,500 of taxable ordinary income. The chart below provides a visual representation of our hypothetical couple and how we calculate their gross tax liability.

Example of how to calculate your gross tax liability

You may have heard a tax term called the marginal tax bracket (or rate). This represents the highest tax rate that's applied to your taxable income, and it also signifies the tax rate at which your next $1 of taxable income would be subject to taxation. For this couple, they are in the 22% marginal tax bracket. So, if they earned another $1 in taxable income then $0.22 of that dollar would be owed for federal taxes.

You'll notice that the marginal tax rate is different than your average tax rate, often called your effective tax rate. The effective tax rate is the average rate at which an individual is taxed on their total taxable income. In our example, the couple's effective tax rate is $27,778 divided by $172,500, which equals 16%. For reference, your effective tax rate will also be less than your marginal tax rate, so long as your marginal tax rate is 12% or higher.

So, to review, we spent some time discussing the process by which your federal net tax liability is calculated along with a discussion about how income tax brackets work. Please know that all the information discussed today is for educational purposes only and should not be taken as tax advice.