Until World War II, everyone was expected to file a tax return and pay the full amount in one lump sum payment at tax time. Since then, however, the federal government has implemented income tax withholding and estimated tax payments throughout the year so that you can pay as you go, rather than having to pay one lump sum with your tax return. Now, if you don’t have enough withheld, you can end up being penalized when you file your tax return on top of owing a big check. To avoid owing taxes when you file your return, you need to carefully manage your tax withholding and estimated tax payments.
Estimated Tax Underpayment Effects
You have a good reason to not want to owe when you file your tax return. Obviously, there is the downside of being hit with an unexpected tax bill that you have to come up with money to pay on short notice. In addition, if you have too little withheld, you can be on the hook for not only the amount you owe, but also interest and penalties. It can be hard to know exactly how much you’re going to owe, so the IRS has two primary safe harbors that you can use to guarantee that even if you owe some taxes, you won’t be penalized.
First, as long as your withholding totals at least 90 percent of what you owe for the year, you won’t be penalized. For example, if when you file your taxes your total tax liability is $11,000, your estimated tax payments plus your income tax withholding from your paychecks must be at least $9,900. If you have $10,000 withheld, you’ll still owe $1,000 with your tax return, but you won’t face any underwithholding penalties. But, if you only had $9,000 withheld, not only would you owe $2,000 in unpaid taxes, you would also face underpayment penalties and interest on the unpaid amount.
Second, you can base your minimum withholding off of your income tax liability from the prior year. Especially if you work in a job that can have large fluctuations in income, such as if you’re paid on commission or self-employed, it can be hard to plan for how much tax you’ll owe before the year is over. By basing your withholding on what you owed the prior year, you have a set amount that you have paid in through withholding and estimated tax payments so that even if you have a lot more income than you expect, you won’t be penalized.
To qualify for the second safe harbor, your withholding and estimated tax payments must equal at least 100 percent of your tax liability from the prior year. If, however, your adjusted gross income from the prior year is more than $150,000, or $75,000 if you’re married but filing separately, the IRS considers you a “higher income taxpayer” and you must pay in at least 110 percent of what you owed the prior year. For example, say your adjusted gross income for last year was $140,000 and you’re single. If last year your tax liability was $15,000, as long as you have at least $15,000 withheld or paid in through estimated tax payments, there’s no penalty. But, if your adjusted gross income is $160,000, even if your tax liability is still only $15,000 because of additional deductions or credits, you would have to pay in at least $16,500 to meet the second safe harbor.
If you don’t meet the safe harbors, the IRS does have the ability to waive the penalty in limited circumstances. For example, if you weren’t able to make the estimated tax payments because of a disaster or other unusual circumstance and it wouldn’t be fair to impose the penalty. The IRS can also waive the penalty if you retired or became disabled during the year or the prior year that you should have made the estimated payments, and it was a reasonable error, rather than willful neglect, that caused you not to make the payments.
Calculating Form W-4 Allowances
To make sure that you have enough money withheld from your paychecks to avoid owing money at tax time, start by making sure your Form W-4, or all of your Form W-4s if you work multiple jobs, are filled out correctly. On the Form W-4, you specify two important factors that your employer uses to determine how much money to withhold: your filing status and the number of withholding allowances you claim. If you don’t submit a Form W-4 to your employer, the employer is required to withhold taxes at the highest rate, which is as if you are single and don’t claim any tax withholding allowances.
Your filing status tells your employer whether to withhold taxes at the single withholding rate or the lower married rate. If you’re single, you’re stuck with the single rate. But, if you’re married, you can either select the lower married withholding rate or you can opt to withhold taxes at the higher single rate by checking the “Married, but withhold at the higher single rate” box. You should consider using this option if you are married but file a separate return from your spouse because the withholding tables for singles more closely resemble the married filing separately tax brackets.
Each allowance you claim on your Form W-4 reduces the amount of your paycheck that’s subject to federal income tax withholding. As a result, the more allowances you claim, the smaller your withholding. If you’re claiming allowances appropriately, that’s a good thing because you don’t want to have too much extra withheld. However, if you want to avoid owing on your tax return, you don’t want to claim more exemptions than you’re allowed.
Use Special Worksheets for Your Situation
To calculate how many allowances you should claim, you can use the IRS Withholding Calculator online, or you can use the worksheets provided as part of Form W-4. If you have multiple jobs, or if you and your spouse both work, you should calculate the number of allowances you are entitled to claim using the Two-Earners/Multiple Jobs Worksheet to calculate your allowances more accurately. When you determine how many total allowances you claim, you should allocate all of those allowances to the highest paying job and then claim zero allowances on all of your remaining Form W-4s for your other jobs.
If you plan on claiming a large amount of itemized deductions or adjustments to income, you should use the Deductions, Adjustments, and Additional Income Worksheet. The basic worksheet doesn’t take into account large amounts of adjustments to income or the larger deductions you might be entitled to if you itemize instead of taking the standard deduction. For example, you could claim thousands of dollars in adjustments to income for contributions to your traditional IRA or from paying student loan interest. Or, if you opted to itemize your deductions, you can write off all of your charitable contributions, certain state and local taxes like income and property taxes, and even mortgage interest paid during the year.
If you’re only working one job and not planning to claim large deductions, you can simply use the Personal Allowances Worksheet to figure the allowances you’re entitled to claim. No matter how many allowances the worksheet you use says you’re entitled to claim, you can always opt to take fewer. For example, if you prefer to receive a large income tax refund, you can claim fewer allowances, or claim 0 on your W-4, to have more withheld to increase your tax refund. But, don’t take more than you can support. If you claim more withholding than you’re entitled to claim, you could face up to a $500 penalty for falsifying your Form W-4.
Accounting for Additional Income
Not all income is subject to income tax withholding, but just because income isn’t subject to income tax withholding doesn’t mean it’s exempt from income taxes. If you have income that isn’t subject to withholding, you will need to make additional income tax payments to avoid having to owe the IRS money when you file your income tax return. Examples of income that aren’t subject to tax withholding are interest, dividends, investment income and self-employment income.
You can remedy the potential shortfall in two ways. First, you can make estimated income tax payments throughout the year so that you won’t owe money when you file your taxes. For example, if you expect to owe $1,000 of taxes on your investment income, you could make quarterly tax payments of $250 each quarter to avoid owing income taxes when you file your tax return.
Second, you can adjust your income tax withholding through your employer to have additional amounts withheld to cover the taxes on your additional income. When you complete your W-4, you’re not allowed to specify a certain dollar amount to be withheld from your paycheck instead of specifying your filing status and how many allowances you want to claim. However, you can request that a specific amount be withheld in addition to the amount calculated under the withholding formula based on your marital status and your allowances claimed. For example, if you’re paid twice a month and you expect to owe $1,000 of taxes on income not subject to withholding, you can file a new Form W-4 that requests an additional $84 be withheld each pay period so that throughout the year so that you won’t owe when you file your tax return.
Making Estimated Tax Payments
Especially if you have income that isn’t subject to tax withholding, consider making estimated tax payments each quarter during the year to make sure that you don’t owe when you file your return at the end of the year. To make estimated tax payments, you can either mail in your payments using 1040-ES or online using the Electronic Federal Tax Payment System. Either way, you’ll need to make the quarterly payments by the following dates: April 15, June 15, September 15 and January 15, unless those days fall on a weekend or federal holiday.
Updating Your Form W-4
Life changes can come at you fast. Luckily, you can update your Form W-4 for your employer at any time – there’s no limit to how many times you can update your withholding. For example, if you get married or divorced, you will want to update your Form W-4 to change your marital status. Similarly, if you start a second job or even a side hustle, you may need to make changes to your Form W-4 to make sure your withholding stays on track. After you complete and submit your new Form W-4, your employer has to start using it to calculate your withholding no later than the first pay period that begins 30 days later. You can download a new Form W-4 from the IRS website any time.
- You can claim fewer allowances, which means more tax gets taken out of your pay. That helps cut the amount you might owe at tax time.
- You might want to claim the fewest allowances for the job with the highest pay because it will have the highest tax rate. This means more tax will be withheld overall, reducing the chance you will owe the IRS money at the end of the year.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."