Tax planning is a year round process. One important step of the process is to work through an income tax projection each summer. That’s the only way to ensure that you won’t be surprised with either a huge tax refund or balance due next April.
A big flaw in the tax system is the annual reconciliation called the Form 1040 that every taxpayer completes and submits to the IRS each winter. The first step is to complete the required tax forms, taking advantage of all the tax breaks available to minimize your income tax liability for the year. In step two, you tally all the taxes you paid in during the year through withholdings and estimated tax payments.
Step three is where things really get exciting. Now is the time to compare your tax liability with the taxes you paid in during the year. If the taxes paid in exceed your tax liability, you’ll be getting a refund from the IRS. Otherwise, expect to write a check on April 15th.
While the small percentage of taxpayers who actually plan ahead and work through a tax projection during the year are generally not surprised by the amount of taxes they owe or will have refunded, it’s fair to say that most everyone else compares step three with rolling the dice at a casino.
The Misleading W-4 Form
A leading culprit of this uncertainty is the benign looking W-4 form. On the surface, the form seems easy enough to complete. Simply fill in your name, marital status, how many allowances you’re claiming, and whether you want any additional taxes withheld from your pay.
Like the W-4 form, the rules governing the withholding tables are simple enough to understand as well. Less taxes are withheld for people claiming to be married than those who claim single. Plus, less taxes are withheld with each additional allowance that is claimed.
So what causes the W-4 form to backfire so often? There are two major underlying problems:
- Each employer withholds taxes as if they’re your only employer
- If you tell your employer that you’re married, the withholding tables assume that your spouse doesn’t work.
If you work for more than one employer, or if both you and your spouse work, you need to be very careful when you complete the W-4 Form. It’s not uncommon for an individual with multiple employers, or a married couple comprised of two working spouses, to owe thousands of dollars in taxes because not enough taxes were withheld throughout the year due to how the W-4 was completed.
The IRS is aware of how misleading the results can be based on how you complete the W-4 form , so has developed an Online Withholding Calculator to use when filling out that form.
Tax planning for salaried individuals tends to be pretty straightforward. For the majority of people on salary, their income doesn’t generally fluctuate much from year to year. And if there is a big fluctuation, their withholdings are automatically adjusted accordingly.
Self-employed individuals don’t have that luxury. Usually, their income changes significantly from year to year. Plus, chances are good that the person is remitting their taxes through quarterly estimates based on their prior year’s tax return. The combination of these two factors results in the potential for big surprises for self-employed individuals each winter.
Do The Math
Some surprises are great, such as surprise birthday parties or perhaps receiving a sizeable gift or inheritance from a long, lost relative you never met. When it comes to taxes, surprises generally aren’t so great.
If you work with a CPA or plan to start working with one for the first time, now’s the time to touch base with your tax preparer and spend a few minutes working through a tax projection.
For do-it-yourselfers, you have a few options. Either re-enter this year’s projected information into your 2014 tax program and see how it comes out. For the most part, the tax rules didn’t change substantially since last year, so this will give you a good idea as to where you stand with your taxes for 2015.
Another suggestion is to print out a copy of your 2014 tax return, and pencil in this year’s numbers in the margin of each form. Even though this method is less precise, you should still be able to get a sense of this year’s projected tax liability.
However you decide to work through the math, taking a little time now will not only help you avoid any surprises next winter, but will also give you the remaining five months of 2015 to adjust your withholdings and quarterly estimates based on your tax projection.