Common reasons people owe taxes + how to not owe the IRS money after filing; preparing to receive a refund; saving money
If you’ve ever filed your taxes and saw that your tax “refund” was looking more like a financial loss, you’ve likely also wondered what you can do to not owe money on taxes.
It happens. But don’t fret — that’s exactly why we’re addressing this topic. We’ll be focusing on the following:
• 3 common reasons people owe federal taxes
• How to not owe money on federal taxes — 3 tips
Nobody wants to owe money on anything. And this is especially true about federal taxes because it’s like the one time you’re expecting the government to give you money, you’re giving them instead! Talk about an unexpected turn of events.
But the tips we provide throughout this article will hopefully help you assess your current circumstances and prepare for a better tax refund next year, and in the years to come.
3 COMMON REASONS PEOPLE OWE FEDERAL TAXES
Certain factors such as the number of allowances you claim to big life changes such as marital or employment status could affect your tax return. Let’s get more in-depth about this.
1. The more allowances claimed on a W-2, the less taxes withheld from a paycheck
Sara from TurboTax gives an in-depth explanation as to how allowances affect your tax refund here. We summarized the main points so you don’t have to read through more text:
• Your employer has you fill out a W-4 form when you start a job
• The more allowances you claim on that form, the less tax is withheld from your paychecks and the more likely you are to owe
But you can avoid this happening again by making changes to the form. We’ll talk about these changes under our “tips” section in a bit.
Essentially, the number of allowances you claim relates to your filing status and the number of dependents you anticipate claiming.
2. Changes in employment status (claiming unemployment; job change; retirement)
Changes in employment status range from receiving unemployment income to taking on an extra job, higher paying job,o self-employment and the like, and could all affect your refund amount.
Some people might be tempted to refer to this reason as “the impact of the pandemic,” but that’s not quite accurate. People have been claiming unemployment, changing jobs, streaming multiple sources of income, and all of that long before Aunt Rona.
The Tax Information Center on the H&R Block website describes 4 ways job and policy changes might have impacted your taxes:
Claiming Unemployment
Over the last year or so, Americans have claimed unemployment benefits in higher numbers than ever before. Unemployment income is taxable at the federal level (and most states).
Due to the American Rescue Plan Act of 2021, unemployment compensation for taxpayers below $150,000 will be able to exclude $10,200 of their income in tax year 2020. When you file, you should include unemployment income on your tax return.
New 1099 Hustle — Freelancing, Side Gigs, Etc.
If you have a freelance or gig job, but haven’t been paying estimated quarterly taxes, that could shed light on the question “why do I owe the IRS?”
As a gig worker, you generally need to pay quarterly estimated taxes on your own. Since there’s no paycheck withholding by an employer in these situations, the job of keeping up with tax payments falls on your shoulders.
Job Changes
If you or your spouse changed jobs last year, you would have completed a new Form W-4. Because completing this form can be tricky, it’s possible that slight changes in how you filled it out affected what you withheld each pay period.
Student Loan Repayment Status
For much of 2020, federal student loan holders got a break on making payments. The downside of not making as many payments means you have a reduced student loan interest deduction, which could cause you to owe taxes instead of getting a refund.
Retirement
Many older Americans are surprised to learn they might have to pay tax on part of the Social Security income they receive. We put it like this: When you retire, you leave behind many things — but a tax bill is not one of them.
• This depends on how much overall retirement income you and your spouse receive, and whether you file joint or separate tax returns.
• You have to pay income tax on your pension and on withdrawals from any tax-deferred investments in the year you take the money.
• The taxes that are due reduce the amount you have left to spend.
• You will owe federal income tax at your regular rate as you receive the money from pension annuities and periodic pension payments.
• If you take a direct lump-sum payout from your pension instead, you must pay the total tax due when you file your return for the year you receive the money.
In either case, your employer will withhold taxes as the payments are made, so at least some of what’s due will have been prepaid. If you transfer a lump sum directly to an IRA, taxes will be deferred until you start withdrawing funds.
Related article(s): FINRA – Taxation of Retirement Income
3. Change in marital status
Big life changes such as marriage or divorce can affect your tax situation such as the filing status for which you are eligible and other aspects of how you are taxed.
For example, changing from Head of Household to Single will affect your tax bracket and the credits and deductions you can take. If you’re married, be sure you understand the difference between the status of Married Filing Jointly vs. Married Filing Separately.
HOW TO NOT OWE MONEY ON FEDERAL TAXES — 3 TIPS
1. Have enough tax withheld or make quarterly estimated tax payments during the year
The key is managing your withholding to get the result you want. The number of allowances you claim relates to your filing status and the number of dependents you anticipate claiming. Over-estimate your dependents or choose a filing status that you are ineligible for and your withholding will always be less than the amount of tax you owe.
You need to remember that the W-4 form you fill out only applies to one employer. So if you earn income elsewhere, your withholding won’t reflect this. You can correct this though.
All you need to do is request additional amounts be withheld each period, regardless of the allowances you claim. You can select any additional amount you like to be withheld.
Summary: Over-withholding means you’ll get a refund at tax time. Under-withholding means you’ll owe.
2. Timing is money… literally
a. Pay for an upcoming tax-deductible expense at a convenient time
From a tax perspective, there’s a huge difference between doing something on Dec. 31 and doing it a day later.
If you know an upcoming expense is going to be tax-deductible, think about whether you can pay for it this year rather than next year. Making January’s mortgage payment in December, for example, could give you an extra month’s worth of mortgage interest to deduct this year!
Similarly, if you know you’re near the threshold for the medical-expenses deduction, moving that root canal up might make the pain more bearable if the cost suddenly becomes deductible, too.
b. Complete your taxes on time to avoid penalties
For each month your tax return is late, the penalty increases by 5 percent, up to a maximum 25 percent. At the time of publication, the minimum penalty for filing a late refund is $135. If you can’t get your taxes completed on time, contact the IRS to request an extension.
• You also want to keep from filing your taxes too early. Wait until you have received all W-2 or 1099 forms from your employers before filing.
• Don’t try to estimate annual earnings based on the year-to-date amount shown on your pay stub.
• Double-check your taxes for accuracy before submitting. A slight mistake can become very costly.
Summary: Submit your tax return on time to avoid late penalties.
Related article(s): Nerd Wallet – 12 Tips to Cut Your Tax Bill This Year; The Nest – Things to Remember When Amending a Tax Return
3. Hop on the donation train
Did you donate clothes, food, old sporting gear, household items, or that hideous reclining sofa that has an unnecessary amount of cupholders and has been sitting in the man cave for two years collecting spiderwebs?
Your spouse might be upset that you got rid of the latter, but the great news is that these types of items are considered cash-less, charitable contributions and are deductible.
You normally have to itemize to claim a deduction for charitable donations, but a provision in the CARES Act allows for everyone to benefit from charitable giving this year. Just don’t forget your receipt.
Filers who claim the standard deduction can claim a deduction of up to $300 in donations, which must have been made in cash (rather than, say, donated clothing or household items) to 501(c)(3) charitable organization.
Many tax software programs include modules that estimate the value of each item you donate, so make a list before you drop off that big bag of stuff at Goodwill — it can add up to big deductions.
IN CONCLUSION
As the year comes to an end, tax planning may not be at the top of your mind. But we’re sure saving money (or getting more money) is always at the top of your mind.
Take a few minutes to review your tax situation and implement our tips — it might help significantly lower your tax bill and give you a larger refund than anticipated. Or seek an experienced advisor to help you make the best of your refund situation!
For all things tax, check out previous articles. Our goal is to seek out the best economic outcomes for our clients. If you’re interested in receiving more financial guidance, including information on taxes like what we’ve just finished discussing, reach out to us here.
