You owed how much on your taxes?

Photo by Kelly Sikkema on Unsplash

Of all the things in life people dread, writing a check to the IRS at tax time is chief among them. Whether you have to write a check for $1,000 or $100,000 the cause is usually less about your tax bracket, and more about underpaying your taxes during the year. This can happen for a variety of reasons.

I’ve written before about using the IRS tax withholding estimator to do a pretty good job of telling you how to adjust your withholding, but there are other common issues that may cause you to have to write a big check in April. If that happened to you this year, or if you want to avoid it in future years, read on.

Common Causes of Underpayment

There are a few common issues that can lead to underpaying your taxes during the year. Here is what to look out for.

• ‍Bonus income - Bonus income is frequently withheld at a federal rate of 22% (in 2024). This can be a problem if your actual tax rate is in one of the higher brackets like 32% or more. Underwithholding by 10% on a $50,000 bonus could mean an extra $5,000 tax bill at filing depending on how things shake out.
• Equity compensation - If you get bonuses in company stock such as Restricted Stock Units (RSUs) or Stock Options (ISOs and NSOs), you again run the same risk of underwithholding at the time of the payout. RSUs and Non-qualified stock options suffer from the same issues as bonus income. Incentive Stock Options have a whole other set of complex rules you should discuss in detail with a tax or financial professional.
• Capital Gains - Sometimes you decide to sell your stock. And if it’s not in an IRA or other tax-deferred account (more on those later) then you might owe capital gains tax on the growth. In small doses it might not have much of an impact. However, if you racked up several thousand dollars of gains from a hot tech stock or an investment a benevolent relative made for you when you were a kid, the tax bill can be substantial. Remember that short-term capital gains occur when you hold the stock for one year or less and are taxed at your regular income tax rate. Long-term capital gains are for stocks held at least one year + one day and receive more favorable treatment, anywhere from 0% - 20% depending on your income level. Remember that selling an investment property can also create similar tax liabilities.
• IRA distributions - Did you take money out of an IRA this year? Even if you’re not retired yet, inheriting an IRA comes with distribution requirements that will leave you with extra taxable income. If you don’t have the investment company holding your IRA withhold tax when you take a distribution, or don’t have them withhold enough, you could wind up owing quite a lot when that IRA distribution hits your tax return as income at tax filing time.
• Self Employment income - Run your own business? Have a side hustle? Pick up some freelance work? In all these instances of self employment you are responsible for paying your taxes, nobody is withholding taxes on your behalf. If the income is substantial or your primary source of income, you will need to make estimated quarterly tax payments or risk owing all the tax at once at tax filing (plus a possible underpayment penalty)! So work with a professional to determine a reasonable percentage of your income to withhold each quarter to pre-pay as estimated taxes. The better your estimate the less you will owe at tax filing time.

What's a taxpayer to do?

While this isn’t a comprehensive list of all the things that will leave you with a balance due at tax filing, they are some of the most common ones I see. So what should you do if one of these situations applies to you?

• Do the math - Or get help doing the math from a pro. Determine how much was under withheld so you know what your potential tax liability is going to be. And compare this with how much is being withheld from your regular paycheck to see how things net out.
• Consider making an estimated tax payment - If you know you’re going to owe a lot from a bonus or from the vesting of stock units, it may be advisable to make an estimated payment to avoid IRS penalties. Business owners should almost always be making quarterly estimated payments.
• If you’re not making an estimated payment, put the money aside in a safe place to earn some interest - The IRS does have provisions to avoid the underpayment penalty, such as paying in at least as much as the previous year’s tax liability. This comes in handy for one time events like a big stock sale or a signing bonus with a new job. In this case you should put enough money in reserve for the tax bill, and put it where it can earn interest in a safe place. Consider something like an FDIC insured high yield savings account or bank CD timed to mature right around April 1st. Both will make sure the money is there when it’s time to file, and earn you a little interest while you wait. Just don’t spend it! If you have a propensity to dip into savings accounts even when you’re not supposed to, making the estimated payment might be your best move.

So don’t get caught at tax time with a big unexpected tax bill. Having to write the check is bad enough, and worse if the money to pay the tax is already spent! Then you wind up in debt to the IRS and nobody wants to see that. Use these tips to anticipate events that might lead to an unexpected tax amount due, and either prepay it to avoid a problem (and penalty) or hold the money in reserve for when you know you’re going to need it.