If you're like most people, you probably like knowing what your future tax liability will be, rather than dealing with unpleasant surprises when filing your return. You can certainly estimate future income tax bills if you have an idea of how much you'll earn, and of which deductions and credits you qualify for. Since it's impossible to predict how the tax laws will change in the future, your estimates may not always reflect what you'll actually owe.
Future Gross Income
The starting point for all tax liability estimates is your expected gross income. Most types of income are taxable, and as a general rule, you should include all future sources of earnings in gross income unless there is a specific tax law that exempts it, such as with municipal bond interest. Common forms of gross income include your wages, self-employment income, alimony, capital gains, and investment income, such as bank interest and stock dividends. Depending on how far into the future you're trying to estimate your tax liability for, you may want to consider things like the salary increases you might receive each year, inflation, and all known factors that will affect your earning potential.
Since your goal is to estimate taxable income, include the tax deductions you may qualify for in the future. Your recent tax returns can provide a wealth of information regarding the type and amount of each deduction that will likely show up on future returns. Figuring out what your standard deduction will be in the future can be one of the most accurate estimates, since the amount increases only slightly for inflation each year. The standard deduction is different for each filing status, so determine whether you'll file as single, head of household, or jointly with a spouse. If you itemize, or think you may in the future, Schedule A lists all potential deductions that you can evaluate.
Exemptions and Credits
Exemptions, which increase for inflation each year, are like deductions, except you don't need to incur specific expenses to report them. Generally, you can reduce your gross income with an exemption for yourself, a spouse if filing jointly, and for each of your eligible children. Also evaluate tax credits -- which reduce the tax you owe rather than your gross income -- that are available for expenses such as higher education, childcare and foreign tax payments. If you're thinking of starting a family or have children heading to college soon, for example, you may want to factor in the impact these family changes will have on your eligibility for tax credits and additional exemptions.
Once you've estimated your taxable income, the tax bracket you'll use to calculate your income tax liability depends on your filing status. Since some filing statuses offer lower rates of tax on larger portions of taxable income than others, it may be a good idea to calculate the tax for different scenarios. For example, if you currently file as single, but it's possible you'll marry and have children in the future, you can compare the difference in tax liability when filing as single versus married filing jointly. To do this, you'll need to use different standard deductions for each estimate and adjust the number of personal and dependency exemptions you take before calculating the tax using the appropriate rates for each filing status.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.