Are you among the millions of taxpayers who dread tax season for fear that you may owe money to Uncle Sam? While receiving a refund is often seen as a financial win, owing money is usually considered an unwelcome surprise. However, understanding what led to your tax bill can help you optimize your finances to make tax time a little less scary. Let’s explore some of the most common reasons why you might find yourself owing money to the IRS.
Understanding US Tax Rates
To get started, let’s look at current tax rates and how the US tax system works.
The US employs a progressive tax model, meaning as your income increases, so does the tax rate applied to your earnings. The chart below illustrates the progressive nature of the US federal income tax system, where higher rates apply to higher income levels. For example, if you are filing single and your taxable income falls within the range of $47,150 to $100,525, you would pay 10% on the first $11,600 of income, 12% on the portion of income between $11,600 and $47,150, and 22% on the remaining income within that range.
2024 Tax Brackets
Tax Bracket
In a progressive tax system, your tax rate increases with your income. The more you earn, the higher your tax rate, with income categorized into brackets to determine these rates. This structure aims to tax individuals based on their ability to pay, meaning lower-income earners contribute a smaller portion of their income than higher earners.
Marginal Tax Rate
Your marginal tax rate is applied to your highest income dollar. It’s the highest tax rate you pay on any part of your income. Your marginal tax rate increases as you earn more income and move into higher tax brackets. For example, if you earn $50,000, your first $10,000 may be taxed at 10%, the next $20,000 at 15%, and the remaining $20,000 at 20%. While your highest, or marginal, tax rate is 20%, only the last portion of your income is taxed at this rate.
Effective Tax Rate
Your effective tax rate is the actual percentage of your income paid in taxes, considering all your deductions, credits, and exemptions. It’s an accurate gauge of your tax burden, offering a more precise picture than just your tax bracket’s rate. Imagine you earn $50,000. After deductions and exemptions, your taxable income is $40,000. If you paid $6,000 in taxes, your effective tax rate would be 15% ($6,000 divided by $40,000), indicating the overall percentage of your taxable income that went to taxes.
Average Tax Rate
The average tax rate is the total amount of taxes paid divided by taxable income, which measures the overall tax burden as a percentage of income. It represents the average rate at which income is taxed and is distinct from the effective tax rate, which considers adjustments such as deductions and credits. If your total income is $50,000 and your total tax paid is $6,000, your average tax rate is 12% ($6,000 divided by $50,000). This rate reflects the percentage of your total income that went towards taxes.
Reasons You Could Owe Taxes
Managing your tax obligation can become complex, especially when faced with scenarios that aren’t straightforward. Many taxpayers find themselves in unique situations that require a deeper understanding of the tax code to avoid unexpected liabilities. Below, we discuss eight common reasons you might owe more taxes than anticipated and share insights on better strategizing for the future.
Working in Another State
If your job takes you across state lines, navigating taxes can get tricky and might increase the amount you owe. States each set their own tax rules and rates, so if you work and live in different states, you’re likely facing unique tax requirements in each. This situation often necessitates filing tax returns in multiple states, potentially increasing your overall tax liability. This scenario is quite common for those living in one state but working in another.
Thankfully, many states offer tax credits or have reciprocal agreements with neighboring states to prevent individuals who work across state lines from paying taxes twice on the same income. But if there is no reciprocity agreement between states or available tax credits, you could find yourself taxed by both states, adding to your tax obligations.
Insufficient Withholding
The information you provide on your Form W-4 determines tax withholdings from your paycheck. If too little was withheld throughout the year (maybe you claimed the wrong number of dependents or your financial situation changed), you could find yourself with a tax bill at filing time.
Multiple Income Streams
If you have more than one source of income, such as freelance work, rental properties, or investments, the taxes withheld from your primary job may fall short of your combined tax obligation. Each income source could have its own tax implications, leading to a shortfall when it’s time to settle up with the IRS.
Changes in Personal Circumstances
Significant life events, such as marriage, divorce, changes in employment status, the birth of children, or even children reaching adulthood can impact your tax liability. Failing to adjust your withholding or account for these changes can result in owing taxes at the end of the year.
Tax Credits and Deductions
While tax credits and deductions can reduce your taxable income and overall tax liability, claiming too many allowances or overestimating your deductions can lead to owing taxes. Additionally, changes in tax laws or the phase-out of certain credits or deductions can catch taxpayers off guard.
Bonuses and Windfalls
Extra income, such as bonuses, commissions, inheritances, or lottery winnings, can nudge you into a higher tax bracket, resulting in a larger tax bill than anticipated. Since these sources of income are often taxed differently than regular wages, it’s essential to plan accordingly to avoid surprises come tax time. Let your tax professional know if you receive any unexpected windfalls so they can advise you on how much you should set aside for the IRS.
It’s important to note that bonuses are not taxed at a higher rate than other income; however, they may be subject to different tax withholding rules, which can sometimes make it seem like they are taxed at a higher rate. The IRS typically considers bonuses to be supplemental income and subjects them to a flat withholding rate for federal income tax rather than your usual withholding rate. This flat rate is often higher than the regular tax rate for your salary or wages.
Self-Employment Taxes
If you’re self-employed or working as an independent contractor, you’re responsible for paying income and self-employment taxes (i.e., Social Security and Medicare taxes). Unlike traditional employees, whose employers contribute half of these taxes, self-employed individuals are responsible for the full amount. Failure to set aside enough money to cover self-employment taxes throughout the year can lead to a hefty tax bill. A competent tax advisor will be able to guide you on what you should be sending to the IRS quarterly.
Underpayment Penalties
In addition to owing taxes, if you didn’t pay enough throughout the year (either through withholding or estimated tax payments), you may also face underpayment penalties, which add to your tax bill. To avoid added penalties, work with your tax advisor and financial advisor on proactively forecasting gains and paying estimated taxes quarterly.
Empower Your Tax Planning
Navigating the complexities of the tax system can be daunting, but being aware of these common reasons for owing money can help you better prepare and manage your finances throughout the year. Consulting with a financial advisor or tax professional can help you make informed decisions to take advantage of all available tax-saving opportunities. With proper planning and understanding, you can minimize surprises and take control of your tax situation with confidence.
Ready to optimize your tax strategies? Schedule a free consultation with us today, and let’s explore how you can maximize your tax-saving opportunities and secure a brighter financial future.
Strata Capital is a wealth management firm serving corporate executives, professionals, and entrepreneurs in the New York Tri-State Area, focusing on corporate benefits and executive compensation. Co-founded by David D’Albero and Carmine Coppola, the firm specializes in making the complex simple to ensure clients feel confident in their financial decisions. They can be reached by phone at (212) 367-2855, via email at carmine@stratacapital.co, or by visiting their website at stratacapital.co.
Cornerstone Planning Group, Inc., (“CSPG”) is an SEC registered investment advisory firm. The information contained herein should not be construed as personalized investment advice and should not be considered as a solicitation for investment advisory service. The information (e.g., tax ) provided is believed to be accurate however CSPG does not guarantee or otherwise warrant such information. For more information regarding CSPG you can refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov) and review our Form ADV Brochure and other disclosures.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.