Under-withholding: Why You Owe So Much in Taxes

Written by: Michael Cooper, CPA

Have you ever received a surprise income tax bill? You’re not alone. According to an analysis of IRS data, just over one-fifth (21%) of U.S. taxpayers owe the IRS money each year. And while owing taxes might not come as a surprise to all those taxpayers, it does to many—often because they didn’t have enough tax withheld from their paychecks.

How does under-withholding happen?

In the U.S., income taxes are a “pay as you go” system, meaning you’re expected to pay taxes throughout the year as you earn income rather than in a lump sum when you file your federal income tax return.

You can do this by having an employer withhold taxes from your paycheck or making estimated tax payments.

If you don’t pay enough throughout the year, you will have to pay the difference when you file your return, and you might also owe interest and penalties. You can avoid an underpayment penalty if you owe less than $1,000 when you file your return or if you pay at least 90% of your current year tax or 110% of the tax shown on your prior return, whichever is smaller.

How do you know how much you’ll owe?

Withholding or making estimated payments is tricky because most people don’t know how much they’ll owe until they file their tax returns. Even if you make “safe harbor” payments based on last year’s tax bill, if your income is higher than last year, you could end up owing a lot of tax even if you manage to avoid an underpayment penalty.

That’s why, if you have taxes withheld from your paycheck, you should update your Form W-4 whenever there is a change to your tax situation.

What is Form W-4?

Form W-4 is a document your employer asks you to fill out. It instructs your employer on how much federal income tax they should withhold from your paycheck and send to the IRS on your behalf.

If you fill out the form right, your employer should withhold the correct amount from your paycheck, and you’ll owe very little when you file—or maybe even get a small tax refund.

The problem is that few people know how to fill out Form W-4 correctly.

How to fill out Form W-4 to prevent under-withholding

Filling out Form W-4 is straightforward if you’re single and have a relatively simple return. But the following situations can cause under-withholding problems.

    • You’re married. If you’re married and your spouse works, you will need to include information on your spouse’s income as well as your own.
    • You have more than one job. If you had another job earlier in the year or work a second job, you need to include information about the income and withholding from that other job.
    • You have other income. You need to ensure your W-4 accounts for all other sources of income, whether tax is withheld on that income or not. That includes retirement distributions, Social Security distributions, capital gains, dividends, unemployment compensation, interest, self-employment income, etc.

So while it might be tempting to fill out your W-4 and turn it in right away on your first day at a new job, you should really take your time. You might even need to look up information on your prior year return or call your accountant to ask questions.

Other situations that might trigger the need to fill out a new Form W-4 include:

    • Getting married or divorced
    • Taking on a second job or starting a business
    • Getting a raise or promotion
    • Inheriting assets
    • Having a child leave home
    • Receiving a large bonus

The IRS’s Tax Withholding Estimator tool is an excellent resource for helping you figure out where your withholding should be. When you enter information about your income and withholding, investments, side jobs, tax deductions, and credits, the tool provides all the information you need to complete the form correctly.

If you were surprised by a tax bill this year, now is a good time to review your withholding. The sooner you make changes, the more paychecks you’ll have to absorb those changes and make your tax withholding and take-home pay even throughout the year.

Of course, if you need help reviewing your withholding or filling out Form W-4, contact your Walter Shuffain advisor.