Hi Friendos,
If you’ve done your 2023 taxes already, you may have run into a situation where you were surprised at the result–either surprised at a big amount owed or surprised about a big refund. Some people love getting a big tax refund as it feels like a wonderful windfall. Personally, I prefer to have use of my money throughout the year. I’ve never met anyone who likes to owe at tax time, although I suppose people exist who celebrate holding on to their funds for the longest time possible to earn some theoretical tiny amount of interest.
For myself, I prefer doing my taxes to be an easy and uneventful financial chore: if I owe that year, I want it to be not very much, and if I’m getting a refund, I also want it to be small. Boring, I like it boring.
So why do people sometimes end up with unwanted excitement around taxes? The simple answer is: either they didn’t pay enough all along the way during the year, or they paid too much throughout the year. The more complicated and precisely accurate answer will be different depending on individual circumstances. As I’ve written about previously, the IRS expect us to pay taxes as we earn income throughout the year.
If you have only self-employment income, this will come down to how much you paid in quarterly estimated taxes during the year. I’m going to write more about this topic next week.
If you have income from multiple sources, you could end up with larger amounts at filing for many reasons:
- Maybe some of your income had no taxes withheld. This is common for investment income: you can see if your financial institution will withhold taxes going forward. It’s also common for self-employment income: you can learn about paying quarterly estimated taxes.
- Maybe you have multiple W-2 jobs and each employer is withholding as if you are in a lower tax bracket because they don’t have a full picture of your total income. You can file an updated W-4 to change your withholding going forward.
- Maybe you got a bonus/commission/severance pay and it only had taxes withheld at 22%, the default withholding rate for bonuses under $1 million. As Nerdwallet explains, the downside of this is that not everyone has an effective tax rate of 22%. If your effective tax rate is higher, you can pay quarterly estimated taxes. If it is lower, you just have to wait for a refund (so try to file early).
- You were unemployed part of the year. If the whole year has already passed, all you can do is wait for a refund (try to file early). If you are partway through, perhaps you can adjust withholding/estimated payments for the rest of the year so the overall result is what you want.
- You are itemizing your deductions and therefore will owe less in tax than default withholding indicates. Consider adjusting withholding/estimated payments if you realize this during the year.
- Your employer made an error in your withholding (this is where a paystub analysis comes in handy in problem prevention).
- You made an error in filling out your Form W-4 when you started your job, so your withholding is off as a result. File an updated W-4 so the issue doesn’t repeat.
Those are just some examples. If you did not like how things turned out when you did your taxes this year, I encourage you to conduct the following exercise:
1. Identify your effective federal tax rate. You take the total amount of federal income tax you owed for the year and divide it by your total income (I like to use adjusted gross income for this exercise).
2. For each income source you had during the year, calculate the % of your federally taxable income that was withheld for federal income taxes (or the amount you sent in for estimate payments as a result of this income source).
3. If an income source had less withheld than your effective tax rate, that contributed to your owing at the end of the year. If it had more withheld, that contributed to a tax refund.
4. You can now take action with the income sources you identified to do things differently going forward and not repeat the problem.
If you did not have a problem but are worried about being on track, say, after a big life change that might impact your taxes, do check out the IRS withholding estimator.
Happy withholding analysis!
-Stephanie
Frequently Taxed Questions 