For many taxpayers, the amount of taxes that you pay can feel like a great mystery—even if you’ve been paying taxes for decades. One year a taxpayer may receive a tax return from the government, and the next be required to pay, leaving taxpayers confused and even distrustful of the IRS. It’s understandable why this may be. Tax language and law is notoriously complex and difficult to understand, and slight differences in the way you complete paperwork can result in huge financial outcomes.
Each year taxpayers across the US find themselves asking, “Why do I owe taxes?” If you’re wondering the same thing, we’re here to help. Read on to learn why you owe taxes this year, and how that amount is calculated.
The Basics on Paying Taxes
While we may only think about paying taxes during tax season, the months leading up to the April 15th tax deadline, the truth is that we pay taxes all year. For W-2 employees, this is done automatically through what is known as tax withholding, the withholding of money from your paycheck throughout the year. This money is a portion of your estimated tax liability for the year. It goes towards things like social security, Medicare, and more.
When tax season rolls around, it is each taxpayer’s duty to submit their income information to the IRS. Based on the information submitted, the IRS calculates your actual tax liability. If the IRS overestimated your tax liability and withheld too much money from you throughout the year, you’ll receive the overage back in what’s known as a tax refund. If the IRS underestimated your tax liability and didn’t withhold enough money from your paychecks, you’ll owe the IRS taxes.
For 1099 taxpayers, the process is fairly similar, but without the involvement of the IRS. Instead, it is the taxpayer’s responsibility to estimate their total tax liabilities, and then split that estimate into 4 quarterly payments, called estimated tax payments. Just like W-2 workers, you’ll submit your income information at the end of each year. If you overestimate your tax payments, you’ll receive a return; if you underestimate, you owe.
Why the IRS Overestimates Tax Withholding
In the most basic sense, the IRS estimates your tax liability based on your yearly income and filing status, and the corresponding tax bracket that you fall into. For instance, if you are single and your income is between $39,475 and $84,199 per year, according to 2019 tax brackets, you’ll be taxed at a rate of 22%. Say you make $50,000 per year. Based on IRS tax brackets, your tax liability will be 22% of $50,000, which is $11,000. Rather than taking $11,000 from you at once, the IRS lessens the impact of your taxes by withholding a much smaller portion of your taxes from each paycheck, totaling up to $11,000 over the course of a year.
Of course, taxes aren’t just based on your corresponding tax bracket. There are many, many circumstances that may increase or decrease your yearly tax liability. Those may be things such as tax deductions and tax credits, filing status, external income from rental properties, personal businesses, etc, and more. These are known as tax allowances, and for each allowance that you claim, your estimated tax liability will decrease.
Remember the tax form you filled out when you started your current job? That is the W-4, also known as the Employee’s Withholding Certificate.
It’s a simple document that allows you to calculate and claim tax allowances, and lets your employer know how much to withhold from your paycheck. If you don’t claim any allowances, your employer will withhold the total portion of your tax liability from each paycheck. As your allowances add up, your employer will withhold less and less.
There is no limit to the number of allowances you can claim, but it’s better to underclaim than overclaim. You can be penalized if you instructed your employer to withhold too little tax from your paycheck. You’re required to pay at least 90% of your estimated tax liability throughout the year. If you’ve claimed so many allowances that your tax payment throughout the year is less than 90% of your total liability, you can be hit with an underpayment penalty of $500 from the IRS.
In order to claim the correct number of allowances on the W-4, you’ll use the Personal Allowances Worksheet, an IRS guide that helps you calculate the right number of allowances for your finances. Instructions for the Personal Allowances Worksheet are as follows:
- First, claim 1 allowance for yourself.
- Claim 1 additional allowance if you’re married and filing jointly.
- Claim 1 additional allowance if you are filing as head of household.
- Claim 1 additional allowance if you are:
- Single or married filing separately and only have one job.
- Married filing jointly with only one job, and your spouse doesn’t work.
- Single, married filing separately, or married filing jointly and you or your spouse have a second job for which your yearly wages are $1,500 or less
- Claim allowances for the Child tax credit, which allows you between 0 and 4 allowances for each eligible child. Your particular number of allowances corresponds to your total income and filing status.
- Claim between 1 and 2 allowances for each eligible dependent based on your total income and filing status.
- Claim additional allowances for other credits determined in Worksheet 1-6 of Pub. 505.
- Finally, tally your total number of allowances.
Note that, for taxpayers with multiple jobs, these guidelines vary slightly so that you’re not claiming multiple allowances at both jobs, which may result in underpayment of estimated taxes and an underpayment penalty.
If you’ve claimed the correct number of allowances for your financial situation, then at the end of each year you should be more or less settled up with the IRS. You won’t receive much of a refund, if any, any you won’t owe very much in taxes, if you owe at all.
If you do owe taxes at the end of each year, it’s likely you’re overestimating your allowances. If you’re looking to reduce the amount of taxes you owe at the end of the year, the simplest answer may be to reduce your number of tax allowances. Note that this will have no actual effect on the total amount of taxes that you have paid by the end of tax season. It will simply cause you to either accurately pay or even overpay your estimated taxes throughout the year. When tax season rolls around, you’ll owe less to the IRS, or may even receive a refund.
Why Do I Owe More Taxes This Year Than I Did Last Year?
Beyond allowances, there are a variety of things that may cause the amount of taxes you owe to shift from year to year. Those may include things such as:
- Changes in marital status: As your marital status changes, your filing status may change as well. For instance, if you went through a divorce over the past year and are now filing alone, you may be pushed into a different tax bracket that could increase the amount of taxes that you owe. If you haven’t updated the allowances in your W-4 to reflect these changes, you may be underpaying taxes throughout the year.
- A new job: Did you or your spouse take on a new job this year? For a new W-2 job, you may have completed your W-4 differently, which could lead to underpayment of estimated tax liability. If you took on a freelance or contract position and didn’t pay your own estimated quarterly tax, you’ll likely owe a significant amount of taxes at the end of the year. Next year, be sure to pay your estimated taxes each quarter to reduce the damage at the end of the year.
- A change in dependents: If you previously claimed the child tax credit and your child has aged out of eligibility, you can no longer claim it on this year’s tax return. Similarly, if a dependent has moved out of your care, you’ll no longer be able to take a deduction or credit for them.
Let’s face it: taxes are confusing, and the way you fill out a form could totally alter your financial situation over the course of a year. If you’re interested in exploring the various ways that you can save money on your taxes, or have questions about the amount you owe, consider exploring tax preparation services from Community Tax. Our experts can consult on your taxes and help prepare you for the upcoming tax year, so that you’re walking away with the most in your pocket. Contact us today.