Tax Bill Caught You Off Guard? Plan Now for Next Year
There is a terrible feeling that sweeps across the nation each year during tax time -- the feeling of horror as you realize you owe Uncle Sam more than expected.
You only have so many options if you find yourself with a big tax liability when you file your income tax return. You can’t change what you did last year -- but you can change your federal income tax situation for next year by altering your W-4 and paying more now.
The 101 on W-4s
Filling out a state or federal W-4 often presents confusion about the number of withholding allowances to take.
Are you following yet? If not, that’s because it’s confusing. Let’s break it down.
Previously, when starting a new job, you would fill out some payroll forms that required you to claim a number of personal allowances -- or exemptions -- which essentially decreased the amount of money you owed to the government. If you took more allowances, then fewer tax dollars would be taken from your check each pay period. The form provided guidance to help you decide how many allowances to take. Then, the withholding amount per pay period would be determined by the payroll department of your company in accordance with the guidelines available on the IRS website.
Fast forward to today: The W-4 still exists, and you may have a similar process to follow for your state taxes. But adding to the confusion, the IRS introduced a new W-4 form in 2020, changing how we set up our income taxes for the foreseeable future.
The new W-4
The new form W-4 works similar to the old one, except instead of selecting “allowances,” you’re guided through the process of selecting a specific dollar amount to withhold from each paycheck. The form W-4 provides a chart that allows you to incorporate different factors to find a suggested withholding amount.
Generally, the less taxes you withhold from your paycheck throughout the year, the more likely you will have to make an additional payment when you file your tax return. If you withhold more taxes before the end of the year, you are more likely to see a tax refund come tax season.
What’s the right number of allowances to take?
Or, rather, given the new W-4, what is the right amount to withhold from your taxable income?
The answer is this: It depends! If you are particularly worried about a large tax bill, then you might want to allow more federal tax to be taken out of your paycheck throughout the year to avoid underpayment. While this may leave you with a big refund (however, that is in no way guaranteed), some personal finance experts say overpaying on taxes is the equivalent of giving the government an interest-free loan.
Self-employed workers have to approach their tax bills differently, as freelancers do not tend to have taxes withheld from their checks and are expected to file quarterly instead of annually. Similarly, if you have additional income streams that are in addition to your salaried job, the W-4 will allow you to take more out of your paycheck so that supplemental income doesn’t lead to a surprise bill come tax day.
The IRS offers a withholding calculator to test out when you have the chance.
Utilize tax credits
While you could theoretically use your W-4 to determine whether you will pay a set amount of taxes throughout the year or all at once, it is also the chance to take whatever deductions the tax law allows.
While filling out your tax forms when starting a new job, or updating those forms if you face significant life changes that would warrant a new filing status, you’ll have the chance to list dependents, which may allow you to take advantage of the child tax credit. Having income between certain levels in certain contexts may also mean you qualify for the Earned Income Tax Credit.
“The income cutoffs vary by state, change yearly, and depend on how many children you have,” says Saundra Davis, financial coach for SaverLife. “You may not even realize you qualify. The IRS has a tool called the EITC Assistant that you can use to check how much tax credit you can claim.”
While some tax deductions may not come into play until filing time, it’s important to keep track of potential itemized deductions throughout the year, especially if you think there’s a chance those deductions will exceed the standard deduction.
For your health
Depending on your employer and insurance situation, you may be able to divert some of your taxable income into a pre-tax health savings account or a federal savings account (FSA) for eligible medical expenses. These accounts allow for an employee to transfer funds into these savings accounts at a tax-free rate. These accounts can then be used to pay for deductibles or certain medical expenses that insurance may not cover. For parents, there is even a federal dependent care savings account that can be used to help cover the costs of childcare.
Assuming these are expenses you’d likely have to cover anyway, opening an HSA or FSA can be an effective way to lower your overall taxable income and save some money. If your company has a payroll or human resources department, you can start by asking if the company offers tax-deferred savings programs for employees.
If you’re struggling financially, retirement is probably the last thing on your mind. But if you can set aside some of your income for retirement, it is a way to reduce your tax burden. There are a variety of retirement account options -- some reduce your tax burden now, while others may allow you to save on taxes later -- so do your research before deciding which is best for you.
“For single or married filers, contributing to your retirement now can help your tax bill later due to the tax-deductible nature of these contributions,” says Conor Richardson, CPA. “Not everyone can contribute the annual limit, so it is essential to plan out your savings to get the biggest bang for your buck.”
You can find out about those limits at the IRS website.
Consult a professional
As we like to say around these parts, every financial situation is different. That is why consulting a tax professional may be your best option if you have questions.
Conor Richardson, CPA, is author of Millennial Money Makeover and founder of ConorRichardson360.com, where he helps Millennials master essential money matters. He has been featured on NBC News, Cheddar TV, Fox Business, The Washington Post, and more.