Imagine you took out a one-year loan in January last year and decided to make payments with every paycheck you receive from your employer. You didn't pay very close attention to the numbers, and you ended up paying more than you owed.
Sometime between February and April the next year, the lender says, “You overpaid. Here's a refund.” And then it takes more weeks to pay you your own money back.
Overpaying that loan was a mistake. It may have caused increased financial stress due to lower cash flow, and that money could've been put to better use like buying groceries, paying down debt, or investing.
But that's not too dissimilar from what's happened when you find out you're receiving a tax refund from the IRS.
On the other hand, if you file your taxes and find you actually owe the IRS, that means you got to benefit from holding onto that money longer. If you plan properly, this can be great news.
Why I'd rather owe taxes with my return
Let's be clear. When you receive a tax refund, that's money you earned, but the government held onto it for several months before it gave it to you. It doesn't give you any benefit for giving it a loan: No interest payment, no bonus, no super secret tax deduction, nothing.
Personally, I'd rather have my money as soon as possible. If the price of keeping more of my money now is owing some of it to the government a few months later — money I'd owe anyway — I'm more than willing to pay that price. It's a lot easier to write a check to the government in April when you had bigger paychecks every month the year before.
Why you owe taxes this year
There are a lot of reasons your tax liability might have changed over the last year, causing you to owe more than what your employer withheld from your paycheck or you paid in quarterly estimates.
Here are a few:
- Your spouse started working. If your spouse started working last year, receiving a similar wage to your own, you probably didn't update your W-4 to withhold taxes at the higher single taxpayer rate. Your employer doesn't know you have other income coming in, so it's not withholding enough.
- You got a divorce. If you separated from your spouse last year, but your employer is still withholding taxes as if you're married filing jointly, you might underpay throughout the year.
- Your child no longer qualifies as a dependent. If you have fewer dependents to claim, your taxes go up.
- Fewer deductions. If you refinanced your home to a lower interest rate, paid less in property taxes, gave less to charity, or put less in your tax-deferred retirement accounts like an IRA or 401(k), you'll have fewer deductions. As a result, you'll owe taxes on more of your income.
- You had capital gains. Your brokerage isn't going to withhold taxes for gains on the sale of stocks and other securities.
- You took a large distribution from your retirement account. If you withdrew more money than usual from a tax-deferred retirement account, you'll owe additional taxes. This also applies if you took the opportunity to do a Roth conversion.
- You started a side hustle. If you run your own business as a sole proprietor or partnership, not only will you have additional income to pay taxes on, but you'll also have to pay self-employment tax.
- Changes in the tax code. When the tax code changes, it can have a big effect on how much you owe.
What to do if you underpaid
If you find you owe money with your tax return, there's no need to panic.
First of all, you won't owe any penalties for underpaying as long as you owe less than $1,000 or you paid 90% of this year's tax liability through employer withholdings and estimated taxes. Alternatively, you're exempt from a penalty if you paid 100% of last year's tax liability, or 110% if your income exceeds $150,000.
Second, make sure you have the funds to cover your tax bill. Filing earlier in the year can help if you didn't set any cash aside for taxes. You'll get an extra month or two to save up or liquidate some securities to make your payment. If you really don't have those funds, you can look into setting up a payment plan with the IRS, but you'll have to pay interest and fees.
Finally, you may need to adjust your W-4 or start paying quarterly estimated taxes. Again, as long as you pay 90% of the current year's tax liability or 100% (or 110%) of last year's, you won't get hit with an underpayment penalty.
If last year's income was higher due to a one-off event — say, you sold some stocks for a huge gain — then you might not need to worry about adjusting your tax withholding and payments. If you expect changes from last year to remain permanent, it's worth staying on the safe side and paying enough to ensure you won't get penalized.
As long as you're avoiding the underpayment penalty and planning for making an extra tax payment in April, owing the government money every year isn't a bad situation. It probably means you're making more money year after year. So that's a pretty good reason to celebrate owing some to the IRS.
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