Why Do I Owe the IRS? How to Avoid Owing Taxes
Navigating the complex tax landscape can be difficult, and finding yourself owing money to the IRS can be extremely stressful. Often taxpayers faced with an unexpected tax liability don’t even really understand why they owe the money. Individuals and businesses find themselves in this situation for a variety of reasons, ranging from insufficient withholding to changes in income.
Wondering why you owe taxes to the IRS? Want to learn how to avoid a surprise tax bill in the future? Then, keep reading. In this article, we’ll go over the most common reasons why people owe taxes, advanced planning techniques to lessen the likelihood of owing, and what you can do if you can’t afford to pay. To get help now, contact us at the W Tax Group today.
Common Reasons Taxpayers Owe
There are several reasons why people and businesses may owe money to the IRS. Understanding these reasons is the first step to avoiding the potential risk of owing, and allows you to make adjustments accordingly throughout the year. Here are some common reasons why people owe the IRS.
One common cause of tax debt is having too little withheld from your paycheck. Tax withholding is a process in which employers deduct income and FICA taxes from the paychecks of employees to cover their estimated tax liability. If you overpay during the year, you’ll get a refund when you file your tax return, but if you underpay, you’ll be faced with a bill.
When you get a new job, you fill out a Form W-4 which helps your employer determine how much to withhold from your paycheck. However, changes in work, filing status, dependency status, and income, as well as your eligibility for credits or deductions can result in owing taxes rather than receiving a refund. For example, if you increased your income through freelancing, the info you entered on your original Form W-4 won’t reflect that fact. Similarly, if you got a divorce but your income stayed the same, your original W-4 won’t reflect that. Thus, in both situations, your employer will end up withholding less tax than needed, and you may end up owing the government more money when tax season comes around.
Income that is not subject to withholding, such as capital gains from stock sales, unemployment benefits, or freelance income, could increase your tax bill. If you sell a stock, for example, you may have more income than normal – and a larger tax bill.
People who get freelance jobs on the side are often surprised by a tax bill. When you work as a freelancer, you have to cover your portion of the Medicare and Social Security contributions as well as the employer’s portion. In contrast, when you’re a W-2 employee, your employer pays half of these taxes, and they withhold your portion from your paycheck so you don’t have to worry about it. As a self-employed person, you must pay these taxes yourself, and that often catches people off guard at tax time.
Changes in Tax Laws
Several changes to the tax code have been made in recent years that may have a substantial impact on how much tax you pay. Even if you usually expect a refund, new tax laws may prevent you from receiving one. When the IRS updated its tax brackets, you may have been affected and placed in another category.
It’s always a good idea to keep an eye on tax reform because if you don’t alter your withholding when things change, you could find yourself owing money.
Additionally, life changes have an impact on your tax bill. When your children grow up and leave home, you can no longer claim them as dependents. Getting married, divorced, or widowed also affects your tax status. Or maybe you got a new job and your income changed dramatically, potentially putting you in a higher or lower tax bracket.
Errors on Tax Returns
Errors on your tax return can have a significant impact on your tax bill. For example, if you enter information incorrectly, such as wages or dividends, the IRS will bill you based on this information. Mistakes on your tax return can result from a variety of causes, including overlooking deductions, misclassifying income, or neglecting to provide important information. Mistakes in bookkeeping, such as missing receipts or failing to document deductible expenses, can also lead to discrepancies.
Once the IRS catches the mistake (through a review or audit), you may face penalties and interest on unreported income. Furthermore, minor errors in calculations or data entry can distort your financial picture, potentially forcing you to owe more than you need to. Examining your tax return thoroughly improves accuracy, reduces the possibility of costly errors, and protects you from unforeseen financial consequences.
How to Not Owe Taxes
You may not want to think about tax until right before the deadline. However, planning ahead can significantly reduce the risk of owing the IRS and lower your tax liability. Here are some approaches you can take throughout the year to avoid dreaded IRS tax bills.
Once you’ve determined how much you underpaid in taxes for the year, you’ll need to alter your tax withholding to ensure that appropriate taxes are deducted from your paycheck each pay period. Then, revise your Form W-4 with your employer and making sure you’re not withholding too little or more than necessary.
When filling out the W-4, you need info about your other jobs, your spouse’s jobs, your number of dependents, and any other income sources. Make sure you have enough tax withheld, but not so much that you’re effectively making an interest-free loan to the government.
Pay Higher Estimated Taxes
Because self-employed individuals do not have an employer who withholds taxes for them, they must pay estimated taxes. Paying the correct amount of tax quarterly throughout the year can help you avoid an unexpected bill at tax time.
But, self-employment income can be unpredictable, making it difficult to estimate how much you’ll owe in taxes after business deductions. Naturally, finding the money for self-employment tax is more difficult than having it withheld from your wages in the first place.
As a self-employed taxpayer, the best way to ensure you set aside enough money for taxes is to keep accurate records throughout the year. Calculate your net income and estimate your tax liability once a quarter and remember to include the self-employment tax.
Consider paying a bit more than you really owe. By paying higher estimated taxes, you guarantee that you are paying the full amount of your tax liability, reducing the risk of owing money to the IRS and instead increasing your chances of receiving a refund.
Tax Deductions and Credits
A tax credit is an amount that can be deducted directly from your tax bill or, in some situations, added to your tax refund. For example, if you have a $1,000 tax bill and claim a $250 credit, you will owe $750. Make sure that you take advantage of all credits possible. The government offers credits for activities ranging from raising children to investing in energy-efficient appliances.
Tax deductions, on the other hand, lower your taxable income. And a lower income equals lower taxes. For example, if you claim a $1,000 deduction, you do not have to pay tax on that $1,000. Businesses can deduct expenses from their income and pay tax on the difference. Additionally, individual taxpayers can choose between itemizing tax deductions on Form 1040 Schedule A or taking the standard deduction each year.
The standard deduction is a dollar amount determined by the IRS each year that is deducted from your gross income. In 2023, the standard deduction for single taxpayers and married couples filing separately is $13,850, $20,800 for heads of household, and $27,700 for married couples filing jointly and eligible widow(er)s. The majority of taxpayers take the standard deduction, but if you have a lot of state and local tax bills, medical expenses, charitable contributions, or other deductions, you may be better off itemizing.
Make Tax-Deductible Retirement Contributions
Every dollar you contribute to an eligible retirement account reduces the amount of income subject to tax. For instance, say you earn $50,000 per year and contribute 14% of your pretax income (or $7,000 per year) to a tax-advantaged retirement account. This contribution reduces your taxable income by $7,000, thus reducing your tax bill accordingly.
The money you put into the account, as well as any gains from your assets, are typically not taxed until you withdraw it at retirement. If you retire in a lower-income tax category, your withdrawals may be taxed at a lower rate.
Note that not all retirement accounts are tax deductible. If you contribute to a Roth IRA, for example, you won’t be able to claim a deduction on your tax return, but the money will grow tax-free and withdrawals are also tax-free.
Advanced Tax Planning
Some people might not want to think about taxes until right before the deadline. However, the importance of tax planning cannot be overstated enough. Here are some advanced tax planning strategies that can help reduce your risk of owing money:
- Organize your tax records: Create a system to keep all of your vital information in one place. For electronic bookkeeping, you can utilize software or save paper records in labeled folders. Add your tax records to your folders as you receive them during the year. Having information readily available will make preparing your return easier and may aid in the discovery of previously ignored deductions or credits.
- Know your filing status: Your filing status is used to determine your filing obligations, standard deduction, credit eligibility, and proper tax. Marriage, divorce, birth, and death can all have an impact on your financial situation, including your filing status and ability to claim certain tax credits and deductions.
- Understand your AGI (Adjusted Gross Income): Your AGI and tax rate are significant considerations when calculating your taxes. AGI is your total income less any adjustments or deductions to your income. In general, the higher your AGI, the higher your tax rate, and the greater the amount of tax you pay. Tax preparation can include making changes throughout the year to reduce your AGI.
Form a Business Entity That Offers Different Tax Advantages
Forming a business entity that offers different tax benefits can be a strategic decision for individuals looking to reduce their tax bills. One such entity worth considering is an S corp. Individuals can potentially profit from pass-through taxation by switching from a sole proprietorship to an S corp.
Unlike corporations, where business income is taxed at the business and individual levels, S corps allow income and deductions to flow through to shareholders, reducing the risk of double taxation. Moreover, S-corp shareholders may be able to structure their compensation to reduce self-employment tax by allocating income as both wages and distributions.
Leverage Tax-Deferred Accounts
Leveraging tax-deferred accounts is a significant method for individuals seeking to reduce their tax burdens. Contributing to retirement accounts, such as 401(k)s or Individual Retirement Accounts (IRAs), allows taxpayers to postpone paying taxes on their contributions until they withdraw funds during retirement. This not only helps to safeguard one’s financial future, but it also delivers an immediate tax benefit.
Contributions to these accounts are usually made with pre-tax dollars, lowering the individual’s taxable income for the year. Furthermore, some businesses match contributions to 401(k) accounts, offering an additional incentive to participate. While Roth IRAs do not provide an immediate tax reduction, they do provide for tax-free withdrawals in retirement.
Individuals can capitalize on compound growth and establish a tax-efficient retirement plan by strategically allocating funds to these tax-deferred accounts, significantly contributing to the goal of minimizing tax liabilities.
What If You Can’t Pay What You Owe?
If you have received a notice from the IRS and are unable to pay, there are several options available to spread the costs or reduce the amount owing. Here are some options worth exploring.
You may be able to spread your payments over 72 months (six years) if you set up an installment plan. If your total tax, penalty, and interest liability is $50,000 or less and you have submitted your required returns, you can request an installment plan through the IRS Online Payment Agreement application. If your debt exceeds $50,000, you must file Form 9465 (Installment Agreement Request) which you can do through the mail, over the phone, or with the help of a tax attorney.
Which payment plans are available to you will be determined by your unique tax situation. Full payment, a short-term payment plan (paying in 180 days or less), or a long-term payment plan (installment agreement) paying monthly are all options.
Submit an Offer in Compromise
An Offer in Compromise (OIC) is a program provided by the IRS that allows eligible taxpayers to settle their tax debts for less than the entire amount owing. This program is intended for people and businesses who are experiencing financial difficulties and cannot afford to pay their entire tax liability.
To qualify for an OIC, taxpayers must show that they are unable to pay the entire tax bill in a lump sum or through payment plans. When reviewing OIC applications, the IRS takes into account criteria such as income, spending, asset equity, and overall ability to pay.
Currently Not Collectable (CNC)
If you find yourself unable to pay the taxes you owe, one option to explore is Currently Not Collectible (CNC) status. This is a temporary relief measure offered by the IRS for taxpayers experiencing financial hardship. When placed in CNC status, the IRS acknowledges the taxpayer’s inability to meet their tax obligations due to financial constraints.
The IRS temporarily suspends collection activities, giving the taxpayer a pardon from collection efforts such as wage garnishment or bank levies. However, it’s important to note that CNC is not a permanent solution, and the IRS may revisit the taxpayer’s financial situation in the future. Typically, the IRS assesses your financial status approximately every two years. If things improve, collections can start up again.
To qualify for CNC, individuals must demonstrate a genuine financial hardship, often by providing detailed financial information about income, spending, assets, and debts to the IRS.
When to Work with a Tax Pro
If you find yourself in a difficult financial situation, such as owing a large amount to the IRS or having difficulty choosing the best plan to minimize your tax payments, it may be time to work with a tax pro. A tax pro, such as a CPA or an agent, can provide useful insights into the nuances of tax laws, assist in navigating complicated IRS processes, and provide specialized advice based on your individual circumstances.
Furthermore, whether you are considering advanced tax planning strategies, incorporating a business entity, or negotiating payment plans or settlements with the IRS, the advice of a tax professional can considerably improve your ability to make educated decisions and optimize your financial situation.
How W Tax Can Help
Whether you’re facing issues related to insufficient withholding, changes in income, or difficulties paying what you owe, W Tax Group is here to help. We provide complete guidance to address your individual tax needs, from altering your withholding and leveraging tax-deferred funds to exploring payment plans tailored to your situation.
By working closely with our clients, we aim to deliver not just immediate tax relief, but also strategic planning to lay solid financial foundations for the future. If you are concerned about your tax bill or need advice on how to reduce the risk of owing taxes to the IRS, call the qualified team at the W Tax Group for a free consultation, and the answers you need.