Note: Before altering your tax strategy, consult with your tax specialist. They have a firm understanding of your wants and needs, as well as the knowledge of tax law required to maximize your wealth potential.
You completed your taxes and were surprised to discover that you owed a hefty sum to the IRS—and maybe even your state. You definitely don’t want a repeat of that next year.
Fortunately, there are ways to help lower your chances of owing so much money when next April rolls around.
Before we dive in to these strategies, be sure to note: Your goal shouldn’t be to get too large a refund; it’s an indication that too much money is being deducted from your paycheck throughout the year (which you subsequently lost the opportunity on which to earn interest). Ideally, you don’t want to owe or get back very much money at tax time.
Now, back to tax-lowering strategies!
Update Your W-4 Form
The IRS W-4 form (Employee’s Withholding Certificate) tells your employer how much federal tax to withhold from your paycheck based on factors including your tax filing status (single, married filing jointly, etc.), how many dependents you have and how much you plan to claim in deductions. Dependents, for tax deduction purposes, can be children or adults whom you’re supporting.
If you’re like most people, you filled this form out when you first started working for your current employer and then forgot about it. However, it’s a good idea to review it if you have a large tax bill, get a large refund, or any time your filing status or number of dependents changes.
Dependents (and Allowances)
One notable change that began on the 2020 W-4 form was the omission of withholding allowances. Prior to the 2020 form, you could claim 0, 1 or 2 withholding allowances, and this would impact how much money was withheld from your paycheck. Claiming 0 allowances would result in more money being withheld from your take-home pay (and therefore, the least chance of owing money to the IRS at tax time). Claiming 1 or 2 allowances would result in increasingly less money withheld from your paycheck, resulting in more take-home pay per paycheck and a smaller tax return (as well as an increased likelihood of owing money to the IRS come tax time).
Withholding allowances and dependents were sometimes conflated by taxpayers. While allowances are now gone from the W-4, dependents are still there. When it comes to dependents, you don’t really have an option. You simply claim the number of dependents living in your household. So, if you have two children, you would claim 2 dependents. Once those children grow up and move out of the house (and are therefore no longer depending on you), you would have to claim 0 dependents. You can’t claim yourself as a dependent. If you do have dependents in your household, there is no benefit to not claiming them. In fact, failing to claim dependents would simply result in you paying more money to the IRS than you actually owe.
Your filing status on your W-4 determines how much in taxes your employer deducts, so it’s important you keep this updated if you don’t want them deducting too much or too little. Changing from “Single” filing status to “Married filing jointly” can make a difference in how much you owe, often to your benefit (and/or your spouse’s). Let’s look at one example to show how changing your filing status on your return can impact how much you owe:
Say you earned $32,200 in income last year. If you were unmarried and filed your tax return as “single” status this past April, your standard deduction would have been $12,550. Subtracted from your total income, that would make your taxable income $19,650. You would have been taxed at a rate of 12%.
Now say your fiancé earned $53,550 last year. If you hadn’t gotten married and they filed their return under the “single” status using the standard deduction of $12,550, their taxable income would have been $41,000. They would have had a tax rate of 22% under the 2021 tax tables. Tax rates increase as income increases.
However, if you got married last year and filed your taxes under the status “Married filing jointly,” you’d have a combined income of $85,750. (We’re assuming no other income for purposes of this example.) Your standard deduction for that status would have been $25,100. That would have put your taxable income at $60,650. The tax rate for married couples filing jointly with that combined income is 12%.
Therefore, as you can see, that puts your fiancé in a lower tax bracket. Although it wouldn’t change your tax bracket in this case, there are other advantages to filing your taxes jointly, like being able to combine deductions if you choose to itemize and find that your combined itemized deductions are larger than the standard deduction. (We’ll get to more about deductions you can itemize in a moment.)
If you’re newly married, it may be wise for you and your spouse to calculate your taxes next year as both “Married filing jointly” and “Married filing separately” to determine which is best for your particular situation before you actually file your taxes. If you file as “married filing separately,” you’ll each essentially be filing your taxes as if you were single. However, the IRS will not allow married people to use the “single” filing status.
So how does all of this relate back to the W-4?
If all of this happened to you last year, you can see how it could potentially change the amount of taxes you owe. In this case, you would likely end up owing less and getting a large refund if you didn’t update your W-4. However, if you went back to filing as a single person (say, after a divorce) or your oldest child moved out of the house and was no longer a dependent, you’d probably find yourself owing more taxes and ending up with a large tax bill.
Either way, it’s best to keep your W-4 current so that you’re paying the taxes you owe throughout the year. There’s not an IRS penalty specifically for not updating your W-4. However, the IRS can charge an underpayment penalty if a taxpayer doesn’t pay at least 90% of the taxes they owe for the year or 100% of the taxes they owed the prior year, whichever of those two amounts is smaller. IRS Publication 505 has more information on underpayment penalties.
Note that you can make other adjustments on your W-4. For example, if you have a second job where federal tax isn’t withheld, you can have the employer your W-4 is filed with withhold additional tax so that you don’t end up owing it next April. The worksheets that are part of the W-4 walk you through the steps for calculating these things based on your own situation. The IRS website has a handy Withholding Estimator that you can reference as well.
If you owed the IRS a lot when you filed your taxes, you may not be having enough withheld each pay period. Tell your employer you need to file a new W-4 with revised information.
Make Quarterly Estimated Tax Payments
If you don’t have an employer who withholds taxes from your paychecks because you are self-employed, you could find yourself owing a lot of money to the IRS when your taxes are due, as we just noted and even facing an underpayment penalty.
You can avoid this by making payments throughout the year using the 1040-ES form. The instructions on that form will also help you determine how much you should pay throughout the year to avoid a big year-end bill (and possible penalties). You can make these payments electronically to the IRS using its Electronic Federal Tax Payment System (EFTPS). The IRS website has information on how to sign up for this system.
Maximize Your Tax-Deferred Retirement Contributions
If you’re taking advantage of an employer-sponsored retirement or profit-sharing plan like a 401(k), your contributions come out of your paycheck every pay period. That means you’re reducing the amount of your income that you have to pay taxes on while building up a nice nest egg.
Typically, the lower your taxable income is, the less you’ll be taxed, as we noted earlier. For example, for 2022, if you’re single and your taxable income is $90,000, you’re taxed at a rate of 24%. However, if you get your taxable income down to $85,000 through contributions to your 401(k), you’ll only be taxed at a rate of 22%.
Even better, most employers match at least a portion of those contributions, so that’s free money.
The IRS has increased the limits on the amount of tax-deferred contributions employees can make to these plans for 2023. You can defer $22,500 for the year (up from $20,500 for 2022). If you’re 50 years old or older, you can make a “catch-up” deferral of $7,500. Check with your employer if you’re not sure how to change your contributions.
If you have a traditional IRA (in addition to or instead of an employer-sponsored plan), you can deduct $6,500 in contributions each year from your taxable income if you’re under 50 years old and up to $7,500 if you’re 50 or older. The IRS website has a lot more information on both traditional and Roth IRAs. (Note that Roth IRAs don’t reduce your tax liability in the contribution year, as traditional IRAs do.)
A word about what “tax-deferred” means: With tax-deferred contributions, you immediately deduct the amount from your taxable income—either on your paycheck as with a 401(k) or when you pay your taxes, as with an IRA contribution. When you eventually access that money, you will pay taxes on it. However, the idea is that by then you’ll likely be working less, if at all, and earning less money, so you’re in a lower income bracket and paying a lower tax rate.
Other ways to maximize your tax-deferred contributions? Check to see if your employer offers Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs).
Increase Your Deductions
Since the standard deduction rate increased significantly beginning in tax year 2018 with the Tax Cuts and Jobs Act (TCJA), you may have found the amount of your standard deduction is higher than if you itemize your deductions. However, that doesn’t mean that you shouldn’t bother to keep track of things you can itemize. Unless you completely account for all of those things, you won’t know for certain whether you benefit by itemizing on your tax return.
Let’s start by looking at a few potentially significant (and often overlooked) deductions:
Sales taxes: If you make a large purchase, like a car, the sales tax is probably a good chunk of change. That’s deductible. You can deduct up to $12,950 in state and local sales taxes annually. The IRS has a handy form to help you.
Medical/dental expenses: Many people don’t bother calculating these if they haven’t had major expenses over the past year. However, more expenses are deductible than you may realize. For example, you can deduct monthly insurance premiums, premiums for a long-term care policy, mileage for travel to and from medical appointments and treatments, psychological and chiropractic care, and more. Note, however, that in Tax Year 2022, you can only deduct the amount that exceeds 7.5% of your adjusted gross income (AGI) on your taxes. For example, say your AGI for 2022 is $50,000. Seven and half percent of that is $3,750. If your deductible medical and dental expenses add up to $6,000, you can include $2,250 in your itemized deductions.
Charitable contributions: Many people don’t keep track of these throughout the year unless they donate a significant amount of money to charity or give several pieces of furniture to Goodwill. However, it all adds up.
We know you’re not volunteering at the local homeless shelter or animal rescue organization for the tax deduction. However, if you’re giving them some money and buying some blankets and toys, this is all tax-deductible if the group is considered a qualified nonprofit organization by the IRS. These typically have a 501(c)(3) code somewhere on their website or literature. The IRS site has more information on what types of charitable donations are deductible. Don’t forget to keep track of donations you make through Facebook and via organizations’ websites. They’ll probably send you a receipt. If not, you’ll at least have a record of the donation on your credit card statement.
Note that donations to political candidates, political parties and political action committees (PACs) are not tax-deductible.
Finally, if you’ve been using a tax preparation software to do your taxes, but finding that you’ve had a large tax bill in recent years, it may be worthwhile to go to a tax preparation service or a certified public accountant (CPA)—at least for one year. It costs more (but in many cases, these services are tax deductible), but if they find areas where you can save on your taxes, it will be more than worth the price.
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