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How to Avoid Owing Money to the IRS

How to Avoid Owing Money to the IRS - TaxACT

Want to make sure you never owe a big tax bill – or any bill at all – when you file your income taxes?

Judging by the amount the average American has over withheld from his or her pay, we’re scared to death of owing the IRS even the smallest amount at tax time.

That’s somewhat curious, considering the average American doesn’t seem that worried about owing money to other creditors. There must be something about the IRS that inspires fear and dread in the hearts of taxpayers.

Overpaying by thousands of dollars “just to be sure” is not the answer. The average tax refund is about $3,000.

That’s a lot of money to be tied up all year, when you could be putting it to better use.

You wouldn’t overpay your electric bill by that much and then think you really scored when you got the excess back.

Why do that with your taxes?

Causes of income tax underpayment

To avoid owing the IRS money, it’s important to know why you might find yourself in that situation.

Here are 5 of the most common reasons people find themselves owing extra tax:

1. Too little withheld from their pay

You can give yourself a raise just by changing your Form W-4 with your employer. However, if you do that without careful planning, you might be setting yourself up for an unpleasant year-end surprise.

2. Extra income not subject to withholding

If you sell stock, for example, you may have more income than usual – and a bigger tax bill. Even unemployment benefits can increase your tax bill.

3. Self-employment tax

For many small business owners, self-employment tax is a far bigger burden than income taxes.

4. Difficulty making quarterly estimated taxes

If you have significant non-wage income, you generally make quarterly estimated payments. However, that’s easier said than done, especially when people feel like they are in financial survival mode most of the time.

5. Changes in your tax return

The kids grow up and move out, and suddenly you aren’t claiming them as dependents. You refinance your home at a lower interest rate. That’s great, but your mortgage interest deduction may have been cut in half.

Even changes in the tax code can make a difference in your tax bill. If you don’t adjust your withholding when things change, you may owe money.

What you should do

The solution to the problem depends on the cause.

Refigure your paycheck withholding

If you’re simply having too little withheld from your paycheck, you can create a new Form W-4 by going through the Form W-4 section under the Next Year main tab in TaxACT.

If you have simple changes to your return, such as fewer dependents, you can enter the changes in this section and TaxACT will determine how you should file.

Take the new Form W-4 to your employer’s payroll department. Do not send it to the IRS.

Have tax withheld from other income

If you have non-wage income, you may be able to have income tax withheld from it voluntarily.

For example, you can have 10% of your unemployment benefits withheld for taxes. That may hurt a little now, but it’s a whole lot less painful than a big tax bill next spring.

To have income tax withheld on government payments, including social security benefits or unemployment benefits, complete Form W-4V from the IRS website and send it to the payer.

Do not send it to the IRS. You can have 7%, 10%, 15%, or 25% withheld from most government payments.

You can only have 10% withheld from unemployment payments.

If you receive pension or annuity payments, adjust your income tax withholding on Form W-4P, available on the IRS website.

If you do not tell an annuity payer how to withhold income tax, the IRS generally requires them to withhold as if you are married and have three dependency exemptions.

Plan for tax on your small business

Self-employed individuals have special challenges paying enough income tax through the year. Their income may be sporadic, and it can be difficult to know how much they will owe after business deductions.

And no one deducts tax from their pay. Naturally, it’s harder to find money for taxes than it is to have it deducted from a person’s pay in the first place.

The only way self-employed taxpayers can be sure they are setting aside enough money for taxes is to maintain good records throughout the year.

Once a quarter, calculate your net income and estimate the amount you owe. Don’t forget self-employment tax.

If you have trouble making your estimated tax payments, consider opening another bank account just for taxes.

Every time you deposit money into your business checking account, transfer the appropriate amount to the tax account.

Then, consider that money untouchable for anything but taxes.

Refigure your tax liability and withholding as needed

Making sure you’re having enough tax withheld or paid in estimated taxes is never a finished task.

Whenever your situation changes – you get married or divorced, you take on a freelance project, for example – recalculate your income if necessary and go through the Form W-4 section under the Next Year main tab in TaxACT again.

It’s a little more work than just paying too much or hoping for the best, but it pays off by giving you a lot more peace of mind about your standing with the IRS.

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About Sally Herigstad

Sally Herigstad is a certified public accountant and personal finance columnist and author of Help! I Can't Pay My Bills, Surviving a Financial Crisis (St. Martin's Griffin). She writes regularly at CreditCards.com, Bankrate.com, Interest.com, RedPlum, and MSN Money. She is an experienced speaker and a member of Toastmasters International. Follow Sally on Twitter.

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