How to Avoid Owing Taxes
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Taking the time to assess your tax situation now, rather than scrambling later, puts you in control. It allows you to avoid penalties, reduce financial stress, and possibly even uncover opportunities for deductions or credits you might otherwise miss.
Avoiding a surprise tax bill comes down to good planning, accurate withholding, and timely payments.
1. Adjust Your Withholding (W-2 Employees)
When you work as a W-2 employee, your employer is required to withhold a portion of your paycheck to cover your federal income taxes (and usually state taxes too). This withholding acts like pre-paying your taxes throughout the year, spreading out your tax payments with every paycheck.
Adjusting your withholding ensures that enough tax is taken out of each paycheck to cover your actual tax liability. Your withholding amount is listed on your W-4.
If you don’t withhold enough — for example, if your W-4 allowances are too high or if your financial situation changes (like getting a raise or a second job) — you may end up underpaying throughout the year. That means you’ll owe a lump sum when you file your tax return, and possibly penalties for underpayment.
Use the IRS Tax Withholding Estimator
- Helps determine if enough tax is being withheld based on income, dependents, and other factors.
Submit a New W-4
- Increase withholding by adjusting allowances or adding a fixed dollar amount.
- Useful if you owed taxes last year or expect a higher income this year.
2. Pay Estimated Taxes (Self-Employed, Side Hustles, Investors)
Estimated taxes are periodic payments you make directly to the IRS (and often state tax agencies) throughout the year to cover your income tax and self-employment tax. They’re meant to approximate the tax you owe on income that isn’t subject to withholding.
Unlike employees who have taxes automatically withheld from their paychecks, people with certain types of income—like freelancers, independent contractors, business owners, investors, and landlords—usually don’t have anyone withholding taxes for them. So, estimated tax payments help spread out your tax liability across the year.
Avoid Underpayment Penalties
- The IRS expects that freelancers and other small businesses and entrepreneurs pay their taxes periodically throughout the year, and not just at the beginning of the next year.
Cover Both Income and Self-Employment Taxes
- Freelancers and self-employed people pay not only income tax but also self-employment tax, which covers Social Security and Medicare.
- Since no one withholds these taxes automatically, estimated payments help cover that liability.
Prevent Big Tax Bills at Year-End
- Without estimated payments, you could face a large, unexpected tax bill when you file your return.
- Paying quarterly lets you budget better and avoid financial strain.
Who Needs to Pay Estimated Taxes?
Estimated taxes are generally required for anyone who expects to owe $1,000 or more in tax after accounting for withholding and credits and who has income not subject to withholding. Common examples include:
- Freelancers and Gig Workers: Income from self-employment, consulting, rideshare driving, or other contract work without tax withheld.
- Small Business Owners and Sole Proprietors: Profits from your business operations.
- Landlords: Rental income that isn’t subject to withholding.
- Retirees with Pension or Social Security Benefits: If your benefits don’t have enough tax withheld.
- Individuals Receiving Other Untaxed Income: Such as alimony (for divorces before 2019), gambling winnings, or cancellation of debt.
3. Avoid Underpayment Penalties
The IRS expects taxpayers to pay their tax liability as they earn income during the year—not just when they file their tax return.
If you underpay, the IRS will assess a penalty based on the amount you underpaid and how long the underpayment remained unpaid.
- Penalties can add up quickly and increase your overall tax bill.
- The penalty is essentially interest charged on the unpaid amount, calculated from the due date of each installment until the payment is made.
- Avoiding penalties means you keep more of your money rather than paying extra fees.
- The IRS can be very strict about underpayment, and penalties are automatic unless you qualify for an exception.
- Penalties add to your tax burden and can trigger closer IRS scrutiny.
Follow the Safe Harbor Rule
The Safe Harbor Rule protects you from IRS underpayment penalties if you pay enough tax during the year, either through withholding or estimated tax payments, even if you end up owing a balance at tax time, if you meet one of the following:
- Pay 90% of current year’s tax, or
- Pay 100% of last year’s tax (110% if AGI > $150,000)
Common Causes of Underpayment
underpaying your taxes is surprisingly common, and it often happens unintentionally. Here’s a breakdown of what causes underpayment and why it happens, especially for people whose financial situations aren’t simple W-2 jobs. Here are some potential causes:
- Raises or bonuses
- Starting a side business
- Large investment gains
Avoiding it takes a little planning—adjusting your withholding, tracking side income, and making estimated payments if needed.
4. Monitor Income Changes Throughout the Year
Recalculate Tax Owed After:
- Salary increases
- New income streams (self-employment, rental)
- Selling stocks, crypto, or property
Adjust Payments Accordingly
- Increase W-4 withholding
- Make extra estimated payments
5. Make Retirement Contributions to Lower Your Taxable Income
Making contributions to certain tax-deductible retirement accounts lowers your taxable income and can help you avoid owing at tax time, such as:
- Traditional IRA
- SEP IRA
- Solo 401(k)
6. Keep Track of Credits and Deductions
Knowing what credits and deductions are available to you can help you make smarter choices throughout the year so you can qualify for them. Pay attention to certain income limits and qualifications you need to consider. Tax laws can vary year to year, so be sure to check on whether you meet the qualifications each calendar year.
7. File and Pay On Time
File Even If You Can’t Pay
- Filing on time avoids the failure-to-file penalty, which is steeper than the late payment penalty.
Use Extensions Responsibly
- File Form 4868 to extend time to file (not to pay).
Conclusion
In short, a small investment of effort throughout the year—checking in on your income, reviewing your withholding, or setting aside money for taxes—can prevent a big bill, penalties, or a financial scramble come tax season. It’s about turning taxes from a yearly headache into a manageable, predictable part of your financial routine.
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