So, you’ve finished your tax return and you owe the government more money than you expected. What happened? Chances are, you didn’t pay enough between your W-2 withholdings and estimated taxes throughout the year.
Nobody likes making sense of tax buzzwords and tax forms (okay, maybe we do a little bit) – but it is important to understand how the government decides what you owe them.
As the hardworking, U.S. citizen or resident alien that you are, you’re subject to federal (and probably state) income tax to support government agencies, services and programs. And if you don’t pay, it’s probably not jail, but it’s definitely not fun.
Tax payments: An overview
Every year, you wait around for some forms, research the cheapest tax software, and wait to see if you’ll get a refund or a bill – without knowing how or why it plays out the way it does each year. No one is saying you have to become an expert – but let’s just talk about the basics: What is happening when you file your personal tax return?
In short, your tax return shows three main parts:
1. How much money you made
2. The tax assessed on that money
3. How much you paid in taxes throughout the year
Your filing status (i.e., single vs. head of household vs. joint) and income from all sources determine your tax rate. Then, your taxable personal income (your total income minus deductions) is multiplied by your tax rate, which will equal your tax liability. You compare your tax liability against the payments you’ve made and voila! Refund or tax due.
Here’s an example:
If you paid federal and state governments too much throughout the year, you get a refund. If you paid too little, you owe.
What income is included on your tax return
When you file your personal tax return, you (and your partner, if filing jointly) are required to report income from all sources. Total income from all sources is also referred to as Gross Income. Here are some examples of the types of income that could be reported on your tax return.
- Wages and Salaries: This is the income received from your employers. It includes regular pay, bonuses, tips, and any other taxable income you earned while working. If you’re an S Corp, this includes the W-2 salary from your S Corp.
- Investment Income: If you’ve got Robinhood, Acorns, Vanguard, Coinbase or similar accounts, you likely have investment income. Any income earned from interest, dividends and capital gains are considered income. Your investment institutions will report your investment income on forms such as 1099-INT, 1099-DIV, or 1099-B.
- Self-Employment or Business Income: If you’re self-employed, you must report all income you earned from your business. If you’re operating as a Sole Proprietor or single-owned LLC, you’ll report this income on Schedule C of your personal tax return. If you’re the owner of an S Corp, you’ll include Schedule K-1 to report the rest of your business profit.
- Rental Income: If you own rental property, you must report all income you received from your tenants. You’ll report rental income and deductions on Schedule E of your tax return.
- Other Income: You must also report income from miscellaneous sources, such as gambling winnings, royalties, unemployment compensation, and social security benefits. You should receive a form from the payer, such as a W-2G, 1099-G, or 1099-SSA, that reports this income.
It’s on you to report your total income from all sources. Even if you don’t receive a 1099-NEC from your clients, you’re still expected to report your income. If you fail to report all your income, it can result in penalties and interest charges (and in the most extreme circumstances, jail).
How to reduce your taxable income
Before the government determines your tax, it gives you an opportunity to reduce your gross income through adjustments and personal deductions. The result is taxable personal income.
Remember, your tax liability is based on taxable personal income, not your total gross income from all sources. If you’re self-employed, your business deductions have already been accounted for on the Schedule C, which will be included in your gross income. If you’re an S Corp then these deductions will be reported on your S Corp’s business tax return. The purpose of this section is to review the adjustments and deductions allowed to reduce your gross income from all sources.
There are two ways the IRS allows you to reduce your gross income: Adjustments and Deductions.
Adjustments to income
Adjustments to income are applied after all your income is totaled (this is what we call gross income). What’s left after adjustments are made is called Adjusted Gross Income (or AGI). AGI is an important number for other complicated things the government imposes, like whether or not you are eligible for certain deductions or tax credits.
Common adjustments to income that you may be eligible for are:
- Contributions to a traditional IRA
- Self-employed health insurance premiums
- Alimony payments
- Student loan interest
- Health Savings Account (HSA) contributions
Deductions from income
Deductions happen after adjustments to income, and the result is Taxable Income. The most important decision is whether you take the standard deduction or itemized deductions.
The Standard Deduction vs. Itemized Deduction is an either/or situation. You get to use whichever results in the higher deduction.
The standard deduction is a flat number that the government adjusts each year for inflation. Every filing status has a different standard deduction amount. In 2023 the amounts are:
- Single: $13,850
- Married filing jointly: $27,700
- Head of household: $20,800
Itemized deductions are a list of expenses (determined by the IRS) that you can deduct from your taxable income. The most common itemized deductions are:
- State and local taxes, including property taxes (up to $10,000)
- Mortgage interest
- Charitable donations
- Medical and dental expenses (above a certain threshold)
- Miscellaneous expenses (such as tax preparation fees, investment expenses, and unreimbursed employee expenses)
If your total itemized deductions are greater than the standard deduction, it would be to your benefit to claim the itemized deductions. The downside in itemizing deductions is more diligent record-keeping – but we are in the age of the internet and technology! Most of your receipts and tax documents will be sent digitally so you can drag and drop into a tax folder throughout the year.
Overall, the choice between the standard deduction and itemized deductions depends on your situation and can change from year to year. If you’re inclined to keep things simple, just know that the tax law changed in 2017 and drastically increased the standard deduction, which means for most people, the standard deduction is more beneficial.
How tax credits work
Tax credits work slightly different from adjustments and deductions. Rather than reducing your income, tax credits reduce your actual tax liability. Common tax credits that you may be eligible for are:
- Child tax credit
- Continuing education credits
- Dependent care credits
- Earned income credit
Types of taxes you may pay
When you file your personal tax return, you could be paying several different types of tax. The taxes you owe will be determined based on the unique circumstance of your combined household income after accounting for any applicable adjustments and deductions.
So what kind of taxes could you be paying?
Income tax is determined on your filing status (i.e., single vs. head of household vs. joint) and total taxable income. This is the tax you pay to the federal and state governments, however not all states have a state income tax, so this will depend on where you live.
Self Employment Tax
Self-employment tax can be called different names: FICA taxes, payroll taxes or Social Security and Medicare. They are used to fund the Social Security and Medicare programs to support you in retirement. When you’re an employee of another company, these taxes are withheld from your paycheck, but if you are self-employed, you pay these taxes yourself.
If you made money from investments or the sale of assets (i.e., sale of your personal residence, rental properties, Robinhood, Acorns, etc.), you may owe capital gains tax or net investment tax on those earnings.
If you have a high-earning household with investment income, your tax bill may also include Net Investment Income Tax. This is an extra 3.8% tax that could be layered onto your tax bill.
How W-2 withholdings and estimated taxes work
Withholdings are tax payments that come out of every paycheck, but those payments only cover your salary, not taxes on other income, like your business income.
Enter: estimated tax payments. Estimated taxes are payments you make throughout the year to the government to make sure you’re putting aside enough cash to cover your anticipated tax bill.
So, if you have W-2 withholdings or are paying estimated taxes, why would you owe more than you paid?
The tax you pay is assessed on your total household income. If you have a partner that works or you have additional income streams, your total tax bill is calculated on the combined income.
Estimating the exact amount of taxes owed can be challenging, because there are many variables to consider, including potential deductions and credits.
If you end up owing at the end of the year, it’s likely due to unanticipated changes in your financial situation, like making more money than you projected or no longer being eligible for tax credits due to increased income.
In such cases, you’ll owe additional tax and penalties and interest may be assessed on the amount owed.
Refund vs. owing: What do I do now?
If you overpaid in taxes throughout the year, the government will owe you money and you’ll get a refund (or you can apply the overpayment to future tax payments!). But if you didn’t pay enough and you owe the government money, you’ve got options.
First things first, the amount you owe is always due by the original tax deadline. Anything you don’t pay by the original due date may be subject to penalties and interest.
That said, you can file an extension and submit an extension payment. An extension gives you extra time to file your return and finalize the details. If you owe the government money, it’s best to pay as much as you can by the original due date (on or around April 15th) to reduce any penalties and interest charges. When you finally do submit your tax return, your extension payment will be included in your “total payments” made.
We’ve covered a lot of ground here but the point is, we’ve got your back! Here are the key take-aways:
- Your tax return includes how much money you made, the tax assessed on that money, and how much you paid in taxes throughout the year.
- Income from all sources must be reported on your tax return and can include wages, investment income, self-employment/business income, rental income, or other miscellaneous income. If you file a joint return, this includes your partner’s activity, too!
- You may reduce gross income with adjustments to income (such as contributions to a traditional IRA) and optimizing between the standard deduction vs. itemized deductions (such as charitable contributions, mortgage interest, etc.).
- Your tax bill may include several different types of tax, including income tax, self-employment/FICA taxes or capital gains and net investment tax.
- Tax credits directly reduce your total tax liability vs. adjustments and deductions that reduce your taxable income.
- W-2 withholdings will only cover the income reported on a W-2, which could include your wages, tips or commissions. Estimated taxes should be reviewed quarterly to ensure your tax bill is covered.
- If more is owed than has been paid in estimated taxes it could be due to an unforeseen change in financial situation (i.e. you made stacks on stacks on stacks).
Overall, it’s important to remember that taking care of your taxes is taking care of your financial future – so stay alert, keep learning, and stay informed!
Marissa Achanzar is part of the sales team at Collective and doubles as a content writer based in Roseville, California. After a successful seven-year-stint in public accounting, Marissa decided to pivot and put her tax compliance and client engagement experience to use by creating practical, people-first educational content.
Marissa is also the founder of Something Good Co., a non-profit that supports foster and at-risk youth in the Sacramento region. In her spare time, she enjoys exercise, trying out new recipes, dabbling on piano or guitar and won’t say no to a good TV/movie marathon. You can find her on LinkedIn or contact her at [email protected]