Too large a refund or a balance due might mean the need to look at what is coming out of your paycheck. Besides taking out from your paycheck for Social Security and Medicare, they also withhold for your federal and state taxes based on the W-4 you completed. The income tax withholding is sent in to the IRS and held in you name until a tax return is filed. It’s then used to pay the tax liability on your return. If there wasn’t enough pre-paid, you have a balance due to pay with the return. Otherwise, you get a refund of the extra withholding as a refund.
Withholding is based on that particular income source; paycheck, IRA distribution or other income. If all you have is one wage income, you shouldn’t have much of a balance due unless your W-4 is not filled out correctly. More than one job, investment income, Social Security, pension or a side business and you can find that you will owe on April 15th even if that income had tax withheld. Yes, you can owe even if everything had withholding. This is an issue for two income families when their W-4s aren’t filled out correctly.
I also see it a lot with clients who take out from their 401(k) or an IRA. They hand me their 1099R and ask if it has to go on the return since they’ve already paid the tax on it. (I’ve never had someone ask if a W-2 has to go on the return because it has withholding.) I tell them yes they have to include it. Later I have to tell many of them why they owe Uncle Sam is because there wasn’t enough withholding taken out of that distribution.
Generally, the withholding on non-wage income is a set percentage. You might be able to override the percent with the payer when everything is set up. Social Security has three percentage rates to choose from. When you retire, you might get a W-4P to fill out for your pension withholding. Most of the time, if they withhold at all, the payer automatically takes out a percentage and sends it to your withholding account with the IRS.
The problem is that no income is taxed alone. It’s added to the rest of your income and taxed that way. Joan and Mark both withdraw $10,000 from their 401(k) and find that 25% ($2,500) has been sent for them to the IRS. 10% will cover the early withdrawal penalty and the remaining 15% will go toward the tax on the distribution itself. For Joan that’s not a problem. She earns $25,000 a year and her W-4 is set up to give her a small refund. Her marginal tax rate is 15%. The additional $10,000 from her 401(k) will all be in the 15% rate or $1,500. The 25% withholding works for her and covers the tax and penalty for early distribution. But Mark makes $60,000 a year and has a marginal rate of 25%. That means the extra $10,000 distribution will be taxed at 25% or cost him $2,500 in taxes plus the $1,000 penalty for $3,500 in tax on the distribution. He’ll owe $1,000 because the 401(k) withholding doesn’t cover the tax on that income.
That’s why good tax planning looks at all your income, deductions and credits. Look at the income you expect to have in 2015 and any life changes that you know will happen. Are you getting married or divorced? Will there be a new baby or will a child move out on her own? Do you now qualify for a deduction or credit or will you lose them? With that information, you or your tax pro can estimate your 2015 tax liability and see if you will have enough withholding to cover the expected tax.
The easiest way is to increase what is prepaid into your IRS account is to change your withholding. This way, you don’t see the money to spend it first or forget to make the estimates. Your tax pro can crunch some numbers and give you some suggested changes. If you are doing this yourself there are W-4 calculators all over the place. The IRS has on online calculator and there are apps for tablets and phone. The key is to take into consideration all of the income you expect to have in 2015 when you estimate your tax liability and what you need to cover it. If you must have a larger refund, add that amount to the tax for the total you need to withhold.
Once you know what you need, you then have to change your W-4 at work. And you must monitor your pay stub until you see the new amount coming out of your check. If your withholding doesn’t change, you might want to check with your Human Resources or payroll person to find out why.
If you don’t want to mess with changing your W-4, you can make estimate payments to the IRS. Pre-paid directly. This is especially helpful for taxpayers who don’t have withholding to tap into. Those who are self-employed and some retirees come to mind.
Will a little tax planning and changing your W-4s mean that you won’t owe on April 15, 2016? There are no guarantees. This is an estimate. Also, any withholding changes you make won’t be for the whole year but it will be better than if nothing was changes. If you didn’t like the results this year and/or you know there will be changes for 2015, a little tax planning and W-4 adjustments might be in order.