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Why Did I Owe Taxes?  The Most Common Reasons Why You Had to Pay the IRS Thumbnail

Why Did I Owe Taxes? The Most Common Reasons Why You Had to Pay the IRS

A common question we get from clients, family, and friends is:  Why did I end up owing money when I filed my taxes this year?  It’s not surprising- no one likes to see a big payment due come April 15!  In order to get to the root cause of the taxes owed, it can be helpful to first ask yourself if this is a new problem or has this been happening for several years now?  Depending on which way you answered, we will discuss some likely potential culprits and steps you can take to avoid running into the same issue in the future. 

Let’s say owing taxes is not a new problem for you- every year has brought a tax bill and perhaps even penalties for under-withholding.  In this case, it is likely that you are encountering one of two issues, both of which can be fixed by adjusting your withholding either through completing an updated W-4 form or adding on some additional withholding through payroll.  

One of the most typical reasons is related to issues with filling out your W-4 form (Employee’s Withholding Certificate) at the start of your employment.  We see this often with clients whose status is Married Filing Jointly (MFJ) and where both partners work outside the home.  Oftentimes, folks get confused when filling out their W-4 and neglect to take time on steps 2-4 where they can get a more accurate withholding estimate for a dual income household.  This leads to the payroll system falsely assuming the only income for the couple is from the job of the employee filling out the form.  This, in turn, can drastically underestimate the total household income, which leads to your withholding level being set far lower than it should.  

The easiest way to fix this going forward is to use the IRS estimator tool (https://www.irs.gov/individuals/tax-withholding-estimator) to help you fill out a new W-4 and input more accurate entries for steps 3 & 4.  Simply reach out to the Human Resources department at your employer to let them know you need to complete an updated W-4.  

The second biggest issue we see that causes under-withholding frequently is having a job where you receive an annual cash bonus or vesting of restricted stock units (RSUs).  It’s natural to assume that this additional lump sum of income would be subject to withholding at the same rate as your regular salary as determined by the W-4 you filled out.  However, the IRS considers this bonus income to be “supplemental wages” and typically levies a flat 22% federal withholding rate.  For folks whose top federal tax rate is 22%, this typically works fine.  But many who earn larger annual bonuses or have vesting of RSUs are at marginal tax rates of 32%, 35% or even 37%.  This can cause significant shortfalls when it comes time to file.  

  • For example, if you earn an annual bonus of $20,000, that will typically lead to $4,840 of federal tax withholding (22%).  If your marginal rate is 32%, you need 7,040 of federal tax withheld from your bonus which will lead to you owing $2,200 at tax filing time.  

One way to mitigate this under-withholding is to check with your HR department to see if you can elect a higher withholding rate on supplemental income.  If not, you can consider adding an additional flat dollar level of withholding to each paycheck that will help cover the anticipated shortfall.   

What if owing taxes is an unwelcome surprise for you?  In the past you filed your return and either got a modest refund or were close to breakeven.  However, this year when you go to file, you find you have a several thousand-dollar tax bill!  Typically, this means you had some kind of major life change and need to consider adjusting your regular withholding or perhaps setting up quarterly estimated tax payments.  Here are some common changes that might lead to a tax bill if not planned for ahead of time: 

  • Changing jobs:  A new job often brings a new salary and perhaps a bonus or equity compensation such as restricted stock or stock option grants.  This may mean you will run into issues covered in the prior discussion on regular under-withholding where you will need to adjust your W-4 or investigate adding on some additional regular withholding amount.  There also may be additional benefits to consider in your new job that would allow you to reduce your tax bill during the year- new choices for retirement account contributions, the option to participate in a deferred compensation plan, or different medical plans with the ability to use an FSA or HSA feature.  It can pay off in tax savings later to carefully evaluate your benefit options during initial enrollment.    
  • Change in Filing Status:  Whenever your tax filing status changes, this could lead to a year with either a big refund or a big tax bill.  It is important to fill out an updated W-4 form to adjust your withholding in the event of a marriage, divorce, or death of a spouse.  These are all events that will trigger a change in your tax filing status and all the tax brackets and thresholds associated with that status in the tax code.  
  • Inheriting investment accounts:  While receiving and inheritance can be very beneficial, it may also trigger additional taxes owed.  In the event where you inherit investments such as stocks, ETFs or mutual funds in a taxable account, you will need to report any investment income from those holdings on your tax return.  This could lead to additional taxes owed (and potentially penalties) when you file if you do not either increase your regular wage withholding or begin making some level of quarterly estimated tax payments to account for this new investment income.  Additionally, if you end up selling any appreciated holdings in order free up some cash to use from the account, this will likely lead to some taxes owed on the realized capital gains.  Taxation on investment income can be complex to determine as it depends on your other sources of income, so working with a tax professional and/or financial planner can be helpful in determining how to address the shortfall.  
  • Starting a new business:  You may have recently decided to start generating additional income through a side business or even fully leave your W2 job to pursue this business.  Many folks who take this path will start out as a sole proprietorship or LLC.  This means that there will be no tax withholding made for any income earned as well as a self-employment tax owed for the portion of Social Security and Medicare taxes that an employer would typically pay.  In these cases, it is often necessary to begin a system of quarterly estimated tax payments to cover your tax obligation and not incur a penalty.  Typically, you will use the form Schedule C to record your business income and expenses when filing your taxes and the result will add on to your total taxes owed.  A tax professional can help you estimate some initial quarterly estimated payments to make as well as a regular system to make payments going forward.  

While no one likes an unplanned tax bill, you can also lose out when you get a refund.  Receiving a refund simply means you overpaid into the tax system throughout the year.  Instead of overpaying the IRS, who won’t give you any interest, you could have been saving more into a retirement plan, investment account or even a high yield savings account.  The goal for tax withholding should be to get as close to what you owe as possible.  

As you can see, estimating your taxes can be complex and it is common to find out you owe a lot at tax time.  The best first step is to try and determine what might be the root cause of your under-withholding.  From there you can try to fix the issue with an updated W4 form and/or consider some level of quarterly estimated tax payments.  We highly recommend working with a tax professional and financial advisor to be truly confident you are prepared for tax time and maximizing your savings potential.  

Liz Alf is the Principal of Clerestory Advisors and fee-only CERTIFIED FINANCIAL PLANNERTM located in Minneapolis, MN.  She is a member of the National Association of Personal Financial Advisors (NAPFA) the Fee Only Network and Wealthtender.  She enjoys serving clients with on-going financial planning and investment management services.