How to Compute Income Tax: A Practical Guide with Examples for Employees, Business Owners, and Mixed-Income Earners

Tags: how to compute income tax, income tax calculation Philippines, BIR tax rules, income tax example, mixed-income earner tax, 8% income tax option

Let’s be honest—tax talk can be overwhelming. But what if computing your income tax in the Philippines could be explained in plain English, step by step, and backed by practical examples?

This blog post is your go-to guide for understanding how income tax is computed, whether you're a full-time employee, a small business owner, a freelancer, or someone juggling both a job and a business. We'll walk you through the concepts, explain the tax rates clearly, and even include a unique example for mixed-income earners using the 8% income tax rate—a topic that's often misunderstood.

Why Income Tax Matters

Income tax is the government’s way of funding essential services—education, roads, public healthcare, and more. As responsible citizens, it’s not just our duty but a contribution to nation-building. But it becomes easier when we know how it works.

The Bureau of Internal Revenue (BIR) administers income taxation under the National Internal Revenue Code (NIRC). The law was updated by the TRAIN Law (Tax Reform for Acceleration and Inclusion), which changed tax brackets and introduced simpler options like the 8% flat tax.

Step 1: Know Your Sources of Income

First, determine your gross income, which is the total amount you earned before any deductions. The BIR classifies income earners into:

Purely compensation earners – salaried employees with no business income
Self-employed individuals – freelancers, sole proprietors, and professionals
Mixed-income earners – individuals with both salary and business/freelance income

Each type is taxed differently, especially when choosing between graduated tax rates and the 8% flat tax option.

Step 2: Choose Between Graduated Rates or 8% Flat Tax (if Qualified)

Now, let’s talk about the two methods for computing income tax.

Option 1: Graduated Income Tax Rates (Based on TRAIN Law)

This is the default system. Here’s how it works, described narratively:

If your taxable income is ₱250,000 or less, you don’t pay any income tax.
From ₱250,001 to ₱400,000, you pay 15% on the excess over ₱250,000.
From ₱400,001 to ₱800,000, you pay ₱22,500 plus 20% of the amount over ₱400,000.
From ₱800,001 to ₱2,000,000, you pay ₱102,500 plus 25% of the excess over ₱800,000.
From ₱2,000,001 to ₱8,000,000, the tax is ₱402,500 plus 30% of the excess over ₱2 million.
If you earn above ₱8,000,000, you pay ₱2.2 million plus 35% of the excess over ₱8 million.

This option is best for those who have high allowable expenses (and thus lower net income) or those earning beyond the ₱3 million VAT threshold.

Option 2: 8% Income Tax on Gross Receipts

This is available only to self-employed or mixed-income earners whose gross receipts do not exceed ₱3 million in a taxable year.

Here’s how it works:

You pay 8% tax on gross income (after subtracting ₱250,000 if you’re a pure business income earner or mixed-income earner).
This tax replaces both percentage tax and graduated income tax.

Important note for mixed-income earners: The ₱250,000 exemption is already used in the compensation portion, so it does not apply again to the business income. You pay 8% on the full gross income from business.

Step 3: Deduct Allowable Expenses (If Using Graduated Rates)

If you're using graduated tax rates for business income, you must choose between:

Optional Standard Deduction (OSD): 40% of gross income. No receipts required.
Itemized Deductions: Actual expenses with supporting documents.

Choose OSD if you don’t want the hassle of tracking receipts.

Step 4: Compute Your Tax Based on Your Status

Let’s explore practical examples to tie it all together.

Example 1: Pure Compensation Earner

Jenny is a marketing officer earning ₱30,000 a month. Her 13th-month pay is ₱120,000.

Annual Salary = ₱30,000 × 12 = ₱360,000
13th-month pay = ₱30,000 (taxable portion over the ₱90,000 cap)
Total Gross = ₱390,000
Less ₱250,000 exemption = ₱140,000 taxable income

Her taxable income of ₱140,000 falls in the 15% bracket.

Tax Due = 15% of ₱140,000 = ₱21,000

Example 2: Self-Employed Using OSD

Leo runs an online t-shirt business and earns ₱800,000 in gross receipts for the year.

OSD (40%) = ₱320,000
Taxable Income = ₱800,000 – ₱320,000 = ₱480,000
Less ₱250,000 exemption = ₱230,000

Tax Due:

The first ₱150,000 (from ₱250,001 to ₱400,000) is taxed at 15% = ₱22,500
The next ₱80,000 is taxed at 20% = ₱16,000
Total Tax = ₱22,500 + ₱16,000 = ₱38,500

Example 3: Mixed-Income Earner Using Graduated Rates

Anna is a teacher earning ₱25,000 monthly and runs a small baking business earning ₱240,000 a year. She uses OSD.

Employment: ₱25,000 × 12 = ₱300,000
Business: ₱240,000 gross × 40% OSD = ₱96,000 deduction
Net Business Income = ₱144,000
Total Taxable Income = ₱300,000 (compensation) + ₱144,000 (business) = ₱444,000
Less ₱250,000 exemption (applied only once) = ₱194,000 taxable income

Tax Due:

₱150,000 taxed at 15% = ₱22,500
₱44,000 taxed at 20% = ₱8,800
Total Tax = ₱31,300

Example 4: Mixed-Income Earner Using the 8% Income Tax Rate

Now let’s say Kevin is a software developer earning ₱40,000 per month and also accepts freelance coding projects earning ₱300,000 a year. He opts to use the 8% tax rate on his freelance income.

On Compensation Income:

₱40,000 × 12 = ₱480,000
Less ₱250,000 exemption = ₱230,000 taxable compensation income

Let’s compute the tax on his compensation:

First ₱150,000 (from ₱250,001 to ₱400,000) = 15% = ₱22,500
Next ₱30,000 (from ₱400,001 to ₱430,000) = 20% = ₱6,000
Total Tax on Compensation = ₱22,500 + ₱6,000 = ₱28,500

On Freelance (Business) Income:

Gross = ₱300,000
Since Kevin is a mixed-income earner, the ₱250,000 exemption is already applied to his employment.
8% of ₱300,000 = ₱24,000

Total Tax Payable: ₱28,500 (compensation) + ₱24,000 (freelance) = ₱52,500

Kevin needs to file BIR Form 1701 as a mixed-income earner and pay both taxes.

Example 5: Self-Employed Using Graduated Rates and Itemized Deductions

Maricel is a freelance interior designer. She earned a gross income of ₱1,200,000 in a year from various clients. She opted to compute her taxes using graduated rates with itemized deductions, meaning she must declare all legitimate business expenses supported by official receipts.

Here’s a breakdown of her annual business expenses:

Office rental: ₱180,000
Utilities (electricity, internet): ₱60,000
Travel and transportation: ₱50,000
Supplies and materials: ₱90,000
Depreciation (laptop, tools): ₱40,000
Marketing and promotions: ₱30,000

Total Itemized Deductions: ₱450,000

Step 1: Compute Net Income

Gross Income: ₱1,200,000
Less: Itemized Deductions = ₱450,000
Net Taxable Income = ₱750,000

Since she is self-employed and not a compensation earner, she is also entitled to the ₱250,000 personal exemption.

Taxable Income after exemption = ₱750,000 – ₱250,000 = ₱500,000

Step 2: Apply Graduated Tax Rates

Let’s compute tax using the TRAIN law brackets:

From ₱250,001 to ₱400,000 = ₱150,000 × 15% = ₱22,500
From ₱400,001 to ₱500,000 = ₱100,000 × 20% = ₱20,000

Total Income Tax Due = ₱22,500 + ₱20,000 = ₱42,500

Recap:

Maricel’s tax due, after accounting for her legitimate expenses through itemized deductions and applying graduated rates, is ₱42,500.

This option works well for those who track expenses diligently and have high deductible costs that can lower their net income significantly.

How to File and When

Here’s a simple filing guide:

For employees: Use BIR Form 1700
For self-employed (OSD or 8%): Use 1701A
For mixed-income earners or those with itemized deductions: Use 1701

The deadline for filing your annual income tax return is April 15 of each year. Quarterly payments (for business income) must also be made on time to avoid penalties.

Final Thoughts: Mastering Your Tax Obligation

Understanding how to compute income tax in the Philippines doesn’t require a degree in accounting. With the right knowledge and examples, you can confidently compute your own taxes or at least understand what your accountant is doing.

To recap:

Know your income sources
Understand the difference between graduated rates and the 8% flat tax
For mixed-income earners, remember that the ₱250,000 exemption applies only once
Always file the correct BIR form
Don’t be afraid to seek help if needed—consult a tax expert or use BIR’s eFPS or eBIRForms for filing

When you understand the system, you take control. And being a tax-compliant citizen? That’s one powerful step toward financial freedom and national growth.

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