Every year, thousands of taxpayers are surprised that they owe income taxes even though their employer withholds taxes from their paycheck each pay period. This is not as uncommon as you may think, and there are many reasons why it could happen.
Check out the list below from RP Financial Services for the five most common reasons why you may owe tax money - and what to do about it?
1. Too little withheld from their pay
Remember when you first started your job and your employer had you fill out a W-4 form? Well the more allowances you claimed on that form the less tax they will withhold from your paychecks. The less tax that is withheld during the year, the more likely you are to end up paying at tax time. But you can avoid this happening again by making changes to the form.
In a nutshell, over-withholding means you'll get a refund at tax time. Under-withholding means you'll owe. Many people try to get as close as possible to even so they get more money in their paychecks during the year, but don't owe a lot or get a bigger refund at tax time. The key is managing your withholding to get the result you are looking for.
2. Extra income not subject to withholding
When you have more income than usual, it leads to a bigger tax bill. Even unemployment benefits can increase your tax bill. Example of taxable income not subject to withholding are, but not limited to: Interest income, dividends, capital gains, self-employment income, gig-economy, IRA (including certain Roth IRA) distributions.
Further, any of these adjustments to income events can trigger a change in your withholding, including IRA deduction, student loan interest deduction, alimony expense. Lastly, changes in your itemized deductions or tax credits can affect your tax bill, such as medical expenses, taxes, interest expense, gifts to charity, dependent care expenses, education credit, child tax credit or earned income credit.
3. Self-employment tax
Self-employment tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners. For many small business owners, self-employment tax is a far bigger burden than income taxes.
Self-employment tax applies to net earnings — what many call profit. You may need to pay self-employment taxes throughout the year. One big difference between self-employment tax and the payroll taxes people with regular jobs pay is that typically employees and their employers split the bill on Social Security and Medicare (i.e., you pay 7.65% and your employer pays 7.65%); self-employed people pay both halves.
4. Difficulty making quarterly estimated taxes
Quarterly estimated tax deposits may be applied to both individual taxpayers and business owners. As an individual taxpayer, if you do not withhold enough tax from your paycheck or owe taxes on a prior year, you are required to make quarterly Estimated Tax Payments toward the current tax year.
As a business owner, you generally have to pay estimated taxes after the end of each quarter, typically based on what you made during that three-month stretch. Missing those quarterly deadlines can prove costly, and the penalties for not paying estimated taxes on time become more severe the more you owe and the longer you go without paying.
5. Changes in your tax return
Life events or changes in the tax code can make a difference in your tax bill. If you don’t adjust your withholding when things change, you may owe money. These events may include marriage, divorce, birth or adoption of a child, home purchase, retirement, filing chapter 11 bankruptcy. A few example can be:
You or your spouse start or stop working or start or stop a second job
The kids grow up and move out, and suddenly you aren’t claiming them as dependents.
You refinance your home at a lower interest rate and your mortgage interest deduction may be cut in half.
What Happens If You Owe Taxes
When you do not pay your taxes by the due date, you will start to accrue interest and penalties on the outstanding amount. Some of those penalties include a penalty for "failure to file," "failure to pay" and "failure to pay proper estimated tax." How penalties are applied can get complicated. According to the IRS, the penalty for the failure to file is a 5% charge of the unpaid tax required to be reported. The penalty will be charged each month or part of a month the return is late, up to five months.
If you compile enough unpaid back taxes (think: owing the IRS $10,000 or more), the federal government will put a lien on your property, most likely your house. You might also get hit with a state tax lien or one from your county. These are documents filed with the county government; if you sell your home, before you see any profits, the government will take what you owe first. Plus, you may also have trouble refinancing a home if you have a lien on it. You may also be subject to liens on your property or garnishment of your wages. In the most extreme tax evasion situations, you may even be subject to up to five years in jail.
What To Do If You Owe Taxes
The solution to the problem depends on the cause. While it is possible to resolve the problem yourself; at some point, you will most likely need to hire a tax professional to fix your tax situation, especially because taxes affect most areas of your life. Since tax laws change all the time -- there are several situations when it makes financial sense to consult a tax resolution professional, who can not only help with preparing your return but also offer smart tax planning advice.
If your financial life is simple, you may be able to handle your own tax issues. Below are some of the most common ways to handle your tax problems:
1. Refigure your paycheck withholding
If you’re simply having too little withheld from your paycheck, you can submit a new Form W-4 to your employer. If you have simple changes to your return, such as fewer dependents, make sure to mention it to your tax professional so that your tax return can be accurately prepared.
2. Tax withholding from other income
If you have non-wage income, you may be able to have income tax withheld from it voluntarily. For example, you can have 10% of your unemployment benefits withheld for taxes. To have income tax withheld on government payments, including social security benefits or unemployment benefits, complete Form W-4V and send it to the payer.
If you receive pension or annuity payments, adjust your income tax withholding on Form W-4P. If you do not tell an annuity payer how to withhold income tax, the IRS generally requires them to withhold as if you are married and have three dependency exemptions.
3. Plan for tax on your small business
The only way self-employed taxpayers can be sure they are setting aside enough money for taxes is to maintain good records throughout the year. Once a quarter, calculate your net income and estimate the amount you owe in taxes. Don’t forget self-employment tax.
Consider opening another bank account just for taxes. Every time you deposit money into your business checking account, transfer the appropriate amount to the tax account. Then, consider that money untouchable for anything but your federal taxes. If you have trouble determining and making your estimated tax payments, consider hiring a tax professional to help you.
4. Refigure your tax liability and withholding as needed
Making sure you have enough tax withheld or pay your estimated taxes in a timely manner. Whenever your situation changes, as mentioned above, recalculate your income if necessary and reconfigure your Form W-4.
The suggestions above are a little more work than just paying too much or hoping for the best, but it pays off by giving you a lot more peace of mind about your standing with the IRS or the State Department down the line.
Staying current and compliance with the taxing authorities is a never ending task. If you have additional questions regarding your tax issues and want to be in compliance, we can help you here at RP Financial Services.
Contact us at (720) 712-7724 or book a FREE consultation using the link: https://calendly.com/rpfs/consult-with-ea
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