Getting to the end of your taxes and realizing you owe lots of money to the IRS is one of the worst feelings in the world. It’s right up there with seeing blue lights flashing in your rearview mirror or hearing your boss say, “Um, yeah . . . we’re downsizing.”
Your heart sinks. And your first question is: Why? Why do I owe taxes this year?
Well, let’s take a look at some common reasons why you might owe so much in taxes. And good news: We’ll show you how you can avoid having that sinking feeling ever again.
Why Do I Owe Taxes This Year?
If you’re used to getting a refund, having to cut a check to the IRS can really throw you for a loop. A tax bill really just boils down to simple math: You owe more taxes than you paid throughout the year. That usually means you didn’t have enough money withheld from your paycheck to cover taxes. But figuring out exactly why you ended up owing Uncle Sam money is a little more complicated. Here are seven reasons why you might owe taxes.
1. Change in Employment Status
If you got a new job this year, your employer probably had you fill out a bunch of paperwork in between handshakes and bathroom breaks. You almost certainly filled out a W-4, which is a tax form that determines how much money your employer will withhold from your paycheck for taxes.
Taxes shouldn’t be this complicated. Connect with a RamseyTrusted tax advisor.
If you filled out your W-4 incorrectly, you could end up owing taxes or getting back a big refund. And the truth is, you don’t want either of those. Your goal is to get a tax refund as close to zero as possible. When you overpay taxes and get a big refund, you’re just giving the IRS an interest-free loan. Don’t let Uncle Sam hold on to your hard-earned cash.
2. Child Tax Credit
Got kids? You probably started getting monthly checks from the IRS last year as part of the expanded Child Tax Credit. Man, wiping those snotty noses is finally paying off! The American Rescue Plan bumped the credit up to $3,000 for children ages 6–17 and $3,600 for children under age 6.1 A portion of the credit was sent out in advance monthly payments starting in July 2021.
But here’s the catch: The amount of the credit was based on the income you reported on your 2020 tax return. And the credit phases out beginning with incomes above $150,000 for married taxpayers filing jointly and $112,500 for heads of household.2 So if your income increased above those thresholds in 2021, the IRS might have sent you too much money for the credit. And the IRS won’t say, “Let’s just call it even.” Nope, not a chance! You’ll have to pay it back when you file your taxes.
3. Self-Employment Income
Did you start a new side hustle to earn some extra cash? Whether you’re driving for Uber or picking up freelance photography jobs, you’ll have to pay taxes on that money. And when you work for yourself, the IRS considers you a self-employed independent contractor.
Having a side hustle can jack up your tax situation because you don’t have an employer withholding taxes from your paycheck. It’s all on you to pay your taxes. A good rule of thumb is to set aside 25–30% of every paycheck for taxes. And in addition to your regular taxes, you’ll be on the hook for the self-employment tax. This 15.3% tax is made up of the employee and employer portions of the Social Security and Medicare taxes.
Not having taxes withheld from your paycheck on a regular basis means you could rack up a pretty big tax bill by the end of the year. Because of this, the IRS requires contractors who expect to owe more than $1,000 in taxes to pay quarterly taxes (also known as estimated tax payments). This means you must estimate your income and tax liability and send a tax payment to the IRS every few months. If you don’t make estimated payments and end up with a tax bill over $1,000 at the end of the year, the IRS will hit you with fees and penalties for underpaying your taxes. No thanks!
4. Capital Gains Taxes
If you bought and sold cryptocurrency or stocks, you’ll have to report capital gains and losses on your tax return. And guess what? The IRS has a special tax for investors called a capital gains tax. Short term capital gains (on assets owned less than a year) are taxed at your regular income tax rate. Long-term capital gains (on assets you’ve owned longer than a year) are taxed at a lower rate.
Not only do cryptocurrency, single stocks or any other flavor-of-the-month investments spark huge tax headaches—they’re also not the way to build wealth. Most people who do that end up getting burned. That’s why the best way to get rich quick is to get rich slow. That means following the 7 Baby Steps and waiting until Baby Step 4 to invest 15% of your income in good growth stock mutual funds. Plus, you’ll get to take advantage of retirement accounts like your 401(k) at work and Roth IRAs that give you tax advantages—not tax hassles!
5. Increased Income
Hey, getting a raise and making more money is great. But a bump in pay could put you in a higher tax bracket. Tax brackets are income ranges taxed at specific rates. So if you’re married and your taxable income falls in the $20,551–83,550 range, you’re in the 12% tax bracket.3 But say you get a big raise at work or your spouse gets a higher-paying job, any income above $83,050 falls into the 22% tax bracket.4 If you don’t adjust your payroll withholdings, you could end up with a big tax bill at the end of the year.
Getting a bigger paycheck also excludes you from the Earned Income Tax Credit, a tax credit that ranges from $560 to $6,935 (depending on your income and how many children you have).5 The maximum adjusted gross income for a married couple with three children to receive the EITC is $59,187.6
6. Life Changes
As philosopher Ferris Bueller once said: “Life moves pretty fast.” Seriously fast. People get married. They change careers. They have babies. And before you know it, the kid who used to sit on the potty and yell, “Wipe me!” is off to college. All of these life changes affect your tax situation.
A big change that can really raise your tax bill is when your dependents are no longer your dependents. In other words, your kids are grown up (18 years old or older at the end of 2022), and you can’t claim the Child Tax Credit.
And if one of those life changes included losing a job and getting unemployment benefits, keep in mind that those benefits are taxable.
7. Lower/Fewer Tax Deductions
Tax deductions lower your taxable income and that means a lower tax bill. Nearly 90% of taxpayers use the standard deduction instead of itemizing deductions.7 But there are a few deductions you can take even if you don’t itemize.
One of these deductions is student loan interest (up to $2,500 per year). But since the Department of Education paused student loan payments and interest through December 31, 2022, you can’t claim a student loan interest deduction. So that might have caused you to have a higher tax bill this year.
But here’s a pro tip: When payments and interest are paused, that’s the very best time to get gazelle intense and have maximum impact on paying off your student loans.
What to Do if You Owe Taxes
A tax bill sucks, but don’t feel like it’s the end of the world. First off, relax. You have options. You’re not going to prison over a tax bill. The IRS doesn’t file criminal charges on honest people who filed their taxes but just can’t afford to pay.
If you can’t pay your taxes, you still need to file your tax return so you don’t get hit by failure-to-file penalties, which are a lot higher than the penalties for not paying your bill on time. Next, start working to pay your bill a little bit at a time. Bills are due by Tax Day, so once that day passes, you’ll start owing interest in addition to the balance you owe.
If you don’t think you’ll be able to pay off your tax bill by Tax Day, you should apply on the IRS website for a payment plan. And guess what? You can set up the plan online without having to call the IRS and wait on hold for hours!
The IRS offers a short-term payment plan (120 days or less) for bills that are less than $100,000.8 Long-term monthly plans are available for balances less than $50,000.9 Long-term plans require a set-up fee that ranges from $31 to $130, but the fee could be waived depending on your income.10
How Do You Avoid Owing Taxes Next Year?
You’ll do just about anything not to have the feeling of owing taxes at the end of the year, right? Well, the great news is that fixing your taxes isn’t as difficult as you might think. You just need to do a little bit of math and fill out a new W-4.
Refigure Your Tax Liability
Okay, so here’s the math part. You need to calculate your tax withholding. This is kind of a two-step process. First, find out how much federal taxes are withheld from your paycheck—just income tax. Ignore Social Security and Medicare taxes. You can find this info on your W-2 or on a paystub. If you’re using a tax total from a paystub, you’ll need to multiply that number by the number of pay periods per year to get your total tax withholding.
For example, let’s say you’re single and make $50,000 a year. You get paid twice a month (24 times per year), and your income tax withholding is $150 per check. That means your total withholding is $3,600.
Next, you’ll need to estimate your tax liability, or the amount of taxes you’re responsible for paying. The IRS also has an online tax withholding estimator to help you with this. Or, if you just did your taxes and have the forms handy, you can see your tax liability there.
Then, just take your tax liability and subtract your withholding to see how much you underpaid your taxes. Once again, if you just filled out your taxes and wound up owing money to the IRS, you should know that number without having to do any math.
Let’s go back to our example. Say your tax liability is $4,300. If you subtract your $3,600 withholding from your $4,300 liability, that means you underpaid your taxes by $700.
Adjust Your Withholding
Once you know how much you underpaid your taxes for the year, you need to adjust your tax withholding to make sure enough taxes come out of your paycheck each pay period. Simply divide your estimated tax shortage by the number of pay periods you have left before the end of the year to get your number. Going back to our example, if you divide $700 by 24 pay periods, you’ll need to have an additional $29 withheld from your paycheck.
Then, you’ll need to fill out a new W-4 tax form with your employer and enter an additional amount you want to have withheld from each paycheck. (You do that on line 4c.) Easy peasy.
Make Quarterly Tax Payments
If self-employment income or money from a side hustle is the main reason why you owe taxes, you have two options. Earlier, we talked about the first option: making quarterly tax payments. Estimating and paying quarterly taxes can get pretty complicated. But if you have another job with payroll withholding, you can increase your withholding from that paycheck to cover the income from your side hustle. That’s your simplest option.
Work With a Tax Pro
If you find yourself in a tax mess, an Endorsed Local Provider (ELP) can help you straighten out your tax situation. These tax pros know their stuff, and that’s why they’re RamseyTrusted.
If you’re confident you can handle your taxes on your own and just want easy-to-use tax software, check out Ramsey SmartTax.