Why Do I Owe Taxes This Year?
While nobody likes to pay taxes, most understand that they are the price you pay to have safe roads, clean water, quality education, and a secure community.
Each year during tax season, people put their income information into a tax calculator and expect to get a refund on their federal income tax return. But maybe you found, to your surprise, that you actually owe the IRS money this year. Why does that happen?
This could really upset your plans if you already had an idea of what you were going to do with your refund check. Here are some reasons you may owe money and how you can avoid the same problem in the future.
Why Do I Owe Taxes This Year?
The number one reason you may not be getting a refund this year is withholding changes. If your personal tax situation remained the same—meaning there was no change in your marital status, income, or number of dependents—there was most likely a change in your withholding status instead.
Many people don’t realize that the Tax Cuts and Jobs Act changed the withholding tables as of February 2018. At first, this change may have seemed like a positive thing, since many people could withhold less money and each paycheck was a little higher than before. However, since they were paying less in taxes with every paycheck, their refund was lowered or they even owed money.
So, why after this change was made did you get a refund (albeit reduced) in 2019 and the next year had to pay taxes? Again, it goes back to the withholding table.
They initially made changes in February 2018, so they were only in effect from February until December 2018. But in 2019 and 2020 tax years, those changes were in effect for the entire fiscal year. This means that you had 12 full months of paying lower taxes, and as a result, your refund was lower or you had to pay taxes.
Fortunately, this situation is easy to fix. You just need to fill out a new W-4. By increasing your withholding throughout the year, you will lower the amount you receive on each paycheck but will also increase your refund rate come tax time.
What Is Tax Withholding?
The practice of withholding income for taxes actually started in 1862 as a way of financing the Civil War. After the Civil War, income tax and tax withholding was abolished in 1872. However, in 1943, under the shadow of the second World War, the current system of tax withholding was implemented.
To clarify, when taxes get withheld from an employee’s paycheck, it is a certain amount of money that is taken from an employee’s paycheck and given to the federal government. This money is viewed as a credit against the annual tax income of the employee. If too much money is withheld, then the government will owe the employee a tax refund. If not enough money is withheld, the employee will have to pay taxes to the government.
This strategy is effective in that it gives the government steady income and allows for tax collection throughout the year rather than collecting after the fact.
The US residents withholding tax is collected by every employer operating in the United States. This money is remitted directly to the government. Employees can have 90% of their estimated income taxes withheld by their employer. This way, they don’t get behind on their income tax or get overtaxed throughout the year.
How Changes in Filing Status Affect Your Tax Situation
1. Job Changes
You may owe taxes because you had several minor changes in your filing status or one major change. For example, if you or your spouse changed jobs, you would have filled out new W-4 forms. You may have made a decision while filling out the form that impacts how much money is withheld each pay period.
2. Filing Changes
Getting married, getting divorced, or having dependents will affect your filing status. This will change how much you are taxed and how much taxes you will owe at the end of the year.
For example, you may have filed as head of the house and now you file as single. This will impact your tax bracket and the deductions you can take. If you got married, learn the differences between married filing separately and married filing jointly. This will also impact how much you will pay in taxes.
3. Your Children Are Older
Recent tax reforms have drastically increased the Child Tax Credits. Now, parents get $2,000 for each child who qualifies.
In order to qualify, a child needs to be 17 years of age or younger at the end of the year. Parents can still get credits for children over 17, but they only get $500. This difference of $1,500 means a lot and can drastically increase the amount of taxes you owe.
4. Money From Your Side Hustle
If you became a freelancer or a contractor, you are making money with no paycheck withholding, so it’s your job to keep up with tax payments. If you’re not making your tax payments quarterly, you may find yourself surprised by how much you owe the IRS at the end of the year.
What Can I Do to Reduce the Amount of Taxes I Owe Each Year?
1. Adjust Your W-4
Your W-4 tells your employer how much tax to withhold. Raise your withholding so that you will owe less during tax time. You can change your W-4 at any time.
2. Put Money in Your 401(k)
The less taxable income you have, the less your tax bill will be. For 2021, you can stash up to $19,500 in your account. If you are over 50, you can throw in an additional $6,500. Some employers will match your 401(k) contribution so you get free money.
3. Contribute to an IRA
You can use a Roth IRA or a traditional IRA. There are limits to how much you can put in an IRA. If you are under 50 years of age, the limit is $6,000 a year. If you are over 50, you can put in $7,000. The nice thing about an IRA is that you have until your tax filing deadline to fund it. This means that if you do your taxes and you see you owe money, you might dump that money into an IRA, minimizing your tax bill and increasing your savings.
4. Charitable Giving
Charitable contributions can be deducted from your taxes. They don’t need to be cash. If you have donated things like sporting gear, household items, and clothing, they can lower your tax bill if they went to a real charity and you got a receipt.
5. Deducting Medical Expenses
If you have had costly dental care or medical care, hold onto those receipts. You are able to deduct medical expenses if they are over 7.5% of your adjusted gross income for the year.
This means that if your AGI for 2020 is $40,000, any medical bill that is beyond the first $3,000 you spend on medical bills is deductible. If you had $13,000 in medical bills, $10,000 of that might be tax deductible.
Taxes are unavoidable, but there are steps you can take to minimize the effect they are going to have on your bottom line. While each individual has a unique tax scenario, planning for your taxes can help you prevent a hefty debt to the IRS.
It’s important to understand that you are taxed not on your gross income but on your taxable income. There are several things that you can do to reduce your taxable income, lower the amount of money you must pay in taxes, or even increase the refund you receive.
If you need help planning or preparing your taxes from a reliable CPA in Washington D.C., Virginia, Montgomery, or Frederick County area, Ontko, LLC is just a phone call away. Get in touch with us for a free consultation today!