“We owed a massive amount in federal taxes!”
“We ended up having a much larger tax bill than we anticipated.”
“How do we get a refund next year?”
And our personal favorite...“I hate filing taxes.”
Tis’ the season for frustrated tax payers. You gather all of your tax documents, spend an entire day entering information into tax software (or your accountants) and hope for a good (or po$itive) outcome. There’s no way you can owe that much money this year… right?!
Alas, your accountant informs you that your tax bill is close to $5,000. How can this be!? You have paid your taxes throughout the past year. You maximized your 401(k)s and Health Savings Accounts (HSA). Where did it all go wrong?
You are not alone. This frustration is apparent with most people we talk to. Despite our mindset that owing the government at tax time is actually considered a ‘free loan’ from the government throughout the year, most people want a refund. They’d rather give that ‘free loan’ to the government, and get their money back during tax time. Therefore, let’s discuss ways you can flip your situation back to getting a refund through adjusting your W-4, calculating your estimated tax bill early, and making quarterly tax payments.
Gone are the days you enter “0” for W-4 allowances because that’s what your coworker told you when you were 25. Literally, those days are gone. Form W-4, also known as the Employee’s Withholding Certificate, was revamped in 2020. The form eliminated allowances. For those that recall, the more you claimed in allowances the less your employer would withhold from taxes and the less you claimed in allowances (“0”) the more your employer would withhold from taxes. The Tax Cuts and Jobs Act eliminated personal exemptions when filing your federal taxes, which eliminated the need to claim allowances.
As stated in the previous paragraph, Form W-4 helps an employer determine what percentage of an employee’s pay should go toward income taxes. The variables in this equation include your tax filing status (single, married filing jointly, married filing separately, etc..) and the number of dependents you claim.
Review 2021 Form W-4 (you may also want this link after reading this blog!)
The 2021 Form W-4 is pretty straight forward. Open the link and scroll down to Step 4, this is where you can begin to add extra withholdings to reduce a large bill come tax time. Step 4 (a) allows you to add any additional withholding to cover income throughout the year that does not have any withholding attached to it such as retirement income, dividends and interest. Step 4 (b) allows you to claim any additional deductions other than the standard deduction.
Step 4 (c) is where we can start planning strategically. Step 4 (c) reads, Extra withholding. Enter any additional tax you want withheld each pay period. The extra withholding you enter on this line is going to impact your net pay or in simple terms, what hits your bank account. Before identifying additional withholding, you need to assess the impact of lowering your household’s cash inflow. If your household cash flow plan shows a large monthly surplus then you can afford to do this, if your household cash flow plan shows a deficit then we may need to reassess this strategy. Let’s say you can afford to withhold additional payments per paycheck on Step 4 (c), now what?
In order to reduce your future tax liability come tax time next year (based on what you owed for 2020) you can solve for additional withholding by dividing your tax liability by the pay periods remaining in the year. For example:
Federal tax owed: $5,000
Pay periods remaining in the year: 20
Additional withholding per pay period Form W-4 Step 4 (c): $250 ($5,000/20)
It’s important to understand that the additional withholding entered in this example is based on your prior year’s income. You may have received a promotion or awarded stock compensation that may increase your federal tax liability when filing next year. This is an estimate and more of an art than a science. The first question you need to ask yourself is if you can afford to do this on an ongoing basis.
Another option to figure out if you are withholding enough through wages is to use the IRS Tax Withholding Estimator. The IRS recently updated the interactive Tax Withholding Estimator. This tool is extremely user friendly compared to their previous version. All you need readily available to run the estimator is your most recent pay stub. The estimator will ask for variables such as income, frequency of pay, federal withholding year to date and withholding per paycheck. Once you complete the steps, the estimator will tell you your potential tax obligation or anticipated refund.
Many of our clients are self-employed and not considered W-2 employees. Many self-employed professionals do not have taxes automatically withheld from pay. The IRS requires you to file quarterly taxes if you meet the following requirements.
You owe at least $1k in federal income taxes this year after all withholdings and refundable credits and your withholdings and refundable credits cover less than 90% of your tax liability for this year or 100% of your tax liability last year.
Quarterly tax payments require better recordkeeping on your behalf because they must be paid 4 times per year as opposed to per paycheck. 2021 Quarterly tax payments must be made by April 15th (for Q1), June 15th (for Q2), September 15th (for Q3), and January 15, 2022 (for Q4) along with filling out IRS Form 1040-ES. The IRS does not allow for you to pay them less than four times a year. Therefore, make sure you have a plan for tackling this in your first year of business and beyond.
Increasing your additional withholdings per paycheck or paying quarterly estimates is a strategy we tend to utilize when W-2 clients are already reducing taxable income by maximizing 401(k) or other pre-tax retirement savings, contributing to deductible Traditional IRAs, or maximizing FSAs or HSAs.
Self-employed clients may already be paying quarterly estimates plus running their pay through payroll. However, we advise self-employed clients to reduce taxable income by contributing to SEP IRAs, Solo 401(k)s or even hiring their children in the business (under 18) because those wages are not subject to social security and Medicare taxes (and it allows your child to contribute to an IRA!).
Yes, everything we discussed earlier was related to your federal tax liability. If you also owed tax from a state level, we’d recommend having a conversation with your financial planner (us!) and your tax professional. If you’d like our help identifying opportunities to reduce taxable income and minimizing your tax liability come future tax seasons then schedule a free consultation with us below.
Disclaimer: This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.