We all love getting a tax refund. Perhaps you have been getting a refund from the IRS for the past several years and you're anticipating one this year. But then you get to the Federal Tax Summary page and instead of a green refund number showing at the top of the screen, you see that red tax due. Or maybe you were expecting to owe a little bit of tax, but the tax due amount is way more than you expected. You ask yourself, “Why do I owe taxes this year?” In Tax Support, we get this question all the time and generally there is a pretty clear reason. Let’s review the possible reasons.
Not enough taxes withheld
The IRS provides Form W-4: Employee’s Withholding Certificate to help your employer estimate how much taxes to withhold each paycheck. It has questions about your income, dependents and other sources of income. It also has lines to withhold extra from each paycheck. One of the most common steps missed or misunderstood is the Multiple Jobs or Spouse Works section. Make sure that it is filled out or you will likely end up not having enough taxes withheld and owing a significant amount of taxes come filing time.
Make sure your W-4 is updated with life changes. You should likely make changes to your W-4 for any of the following life changing events:
- You get married.
- One spouse goes from being a homemaker to being employed or self-employed.
- You have a child, and again for each additional child.
- You or your spouse takes on additional employment or self-employment.
- Your child turns 17 years old by the end of the tax year.
- Your child is over the age of 19 and works full-time rather than attending college full-time.
- Your child is between 19-24 and they graduate college and start their career.
- Your child turns 24 years old while a full-time college student.
Not having enough taxes withheld from your paycheck is the most common problem. Let’s continue and discuss other reasons you may owe taxes you weren’t expecting.
Penalties and taxes on early retirement distributions
When you leave a job where you had a retirement plan, you may be forced to take a lump sum distribution from the retirement account. This could be a small amount or a large amount depending on how much you contributed or how long you worked there. If you don’t roll it over to another qualifying retirement account within 60 days, the whole distribution is subject to taxes and maybe even penalties.
The penalty for an early retirement distribution is 10%.
Then you also have to report the distribution as taxable income and you may not have had any taxes withheld. Either one of these will increase your taxes due or reduce your refund.
Make sure you talk to your human resource department about how to deal with your retirement account when leaving. You can avoid big headaches when it comes to tax filing time.
Taxes on business income
Many people are starting their own businesses, from driving for a rideshare to selling things online. The additional taxes on business income can increase your taxes more than you expected. Net business income is taxed in two ways. First, it is added to your adjusted gross income and subject to income taxes if you have taxable income. Second, business income is subject to self-employment taxes regardless of your taxable income. Self-employment tax is about 15% and catches a lot of people off guard.
Depending on how much self-employment income you expect to make, consider making quarterly estimated tax payments to the IRS and your state. The IRS has worksheets available to estimate your taxes. A safe estimate may be paying at least 25% of your net business income as estimated tax payments. Traditionally, estimated tax payments are made quarterly by using Form 1040-ES. However, it is possible to make payments as often as is convenient for your finances using electronic payment options like IRS Direct Pay. Paying estimated tax payments will help you avoid any tax surprises. And remember, you can always claim a refund of any overpayments you make.
Sale of property
If you have a valuable asset you sold this year, that can increase your income and therefore your tax liability. For example, an inherited home, a rental property or a piece of land can all produce a large capital gain which you will be taxed on. In most cases, owning property for more than one year will save you money when you sell. Plan ahead and pay an estimated tax to the IRS for the gain. This will prevent you from owing more than you expected when tax time comes.
If you sell the home you lived in for more than 2 years, that doesn’t generally generate a taxable capital gain unless the gain was more than 250,000 dollars (or 500,000 dollars if you’re filing a married filing joint tax return).
Sales of stock and securities
You sold some stock this year which has increased in value. The gain on that sale will increase your taxable income and therefore your tax liability. Long-term gains are taxes at the next lowest tax bracket, which is a nice tax advantage. However, plan ahead by making sure you set aside enough to pay the taxes on that gain.
Marketplace insurance premium credit
Do you have health insurance through the government Marketplace? If so, did your income increase from what you reported when you applied for insurance? For example, did you get an early withdrawal from your retirement account or get a higher paying job? If so, there is a chance you may have to pay back part or all of your advanced premium tax credit. This is a tax that most people have no idea can happen and catches many totally off guard. Take the time to educate yourself at HealthCare.gov about changes to your income, household or a life change. Updating your information on HealthCare.gov will help you avoid the surprise in a high tax bill.
Lump sum payments
Did you apply for early social security benefits and after a couple years win your case? If so, you may have received a large lump sum payment. If enough taxes were withheld, you’re okay, but if not, you could be paying more taxes than you expected. Working with the Social Security Administration to have enough taxes withheld can prevent this unpleasant surprise.
Perhaps you won a lawsuit and received a large lump sum payment. In most cases that income is taxable and reported on a 1099-MISC. It may even include the legal fees that were paid to your attorney, since those attorney fees are not deductible. You have to report the full amount and will end up paying taxes on the gross amount. Talk with your attorney and see what tax advice you can get about avoiding a big tax burden come tax time. You may even want to pay estimated taxes to the IRS on the lump sum.
These are the most common reasons you may end up owing more taxes than you expected. There’s a way to avoid the taxes by making estimated payments or increasing your withholdings. Understanding the possible reasons and a little bit of planning can help you avoid owing more taxes than you expected.