You Should Know: The Difference Between Tax Liability and Tax Expense
Today is one of the days that the personal finance crowd takes a walk in the accountants’ shoes to learn some vocabulary that will help them analyze their own personal tax situation. In everyday conversation, many people will use the terms “Tax Liability” and “Tax Expense” interchangeably when it comes to their personal finances. On the other hand, accountants make a very clear distinction between the terms “Liability” and “Expense” and use these terms to describe two different things. Let’s start with what these terms mean to the accountants:
Liability - An amount owed to another party at a particular point in time. People typically understand this as the amount they owe when they file their tax return.
Expense - The amount of burden created over a particular period of time. People typically
Let’s say that a person made $50,000 during 2020, and they had a total of $4,000 withheld from their paychecks for federal taxes ONLY. The amount of federal taxes for the year (utilizing the standard deduction, but before any other adjustments) would be $4,315. This amount represents the federal tax expense for the entire year. A few months after the year is over, this person files their return and notes that they owe $315, which is the difference between the total expense of $4,315 and the amount withheld of $4,000. This $315 represents the federal tax liability with filing the return.
I’m Not an Accountant, Why Should I Care?
When I speak with friends about their taxes, they are usually concerned with the amount that they owe when they file their tax return (the tax liability). When average people don't like the amount they owe at the end of the year, the best thing they can do is change their withholdings, so more money is taken out gradually instead of all at once. However, doing this will only reduce the tax liability at the end of the year and not the total tax expense. Examples of things that reduce total tax expense are:
Contributing to a traditional retirement account such as an IRA or a 401k
Itemizing deductions such as medical expenses, state and local taxes, and mortgage interest
Qualifying for certain tax credits such as the earned income tax credit or a child tax credit
While other options may be available to those who run their own business and have a means to offset that primary business income with expenses, the vast majority of people will only need to deal with these three areas listed above.
It's important to remember that taking advantage of these things and reducing your total tax expense can certainly help you reduce your tax liability, but ultimately the amount that you owe when you file your return is a function of both the amount of taxes that you will ultimately have to pay the government and the amount you've already paid.
So, the next time you talk to your accounting friends and ask them how you can pay less taxes, be sure to remember the difference between tax expense and tax liability. Remember, it’s quite easy to reduce your tax liability at filing, just pay more through withholdings! It’s a bit trickier to reduce the tax expenses you pay for a tax year.