The IRS is not trying to trick you. They don’t want you to owe a lot of money; it doesn’t do anybody any good. But it happens, and here are some of the most common reasons why:
- Checking the “married” box on your W-4. Changing from “single” to “married” on your W-4 causes significantly less tax to be withheld from your paycheck each pay period. This is due to (I assume) an archaic assumption about married, single-income households. If you get married and both spouses continue to work, then there’s generally no change to your combined/overall tax situation, and as a result you can end up being severely under-withheld by checking the “married” box on your W-4. A lot of recently-married couples end up owing at tax time even if they’d never owed anything previously; this W-4 issue is almost always the reason why. They’ve updated their W-4 with their employer, checked the “married” box, had a significant decrease in their tax withholding, and then have to make up the difference at tax time.
- Withdrawing money from a retirement account, before retirement age. Generally, when you take an early distribution from a retirement plan, federal and state taxes will automatically be withheld. However, in most cases, the withholding (especially federal) is insufficient. If, for example, you have 10% federal tax withheld, but you’re actually in the 25% tax bracket and subject to the additional 10% early-withdrawal penalty, then you’re under-withheld by 25%. On top of that, if you’re making a very large withdrawal, then many of your typical tax deductions and tax credits can be reduced as a result of having a higher overall income for the year. It can be a real mess; I’ve seen people owe many thousands of dollars for this kind of thing.
- Taking a 2nd job. Be careful with this one. If you take a second job, you’ll want to reduce your withholding for your primary job, to cover the taxes due on the additional income. (Even though you’re having taxes withheld from the income from the second job, it’s almost never enough.) And if you’ve got three or four or five jobs, none of which pay very much, you can inadvertently get yourself into a really ugly position; you may owe a significant amount in tax because your combined income is high, but each job may withhold only a very small amount in taxes (since as far as they know, your income is very low).
- Taking on contract (self-employment) work “on the side.” Assume that anywhere from 20-45% of what you’re getting paid will need to go towards taxes. See here.
- No longer qualifying for the Earned Income Credit. The rules on the earned income credit aren’t terribly intuitive. If you qualify in one year, you may get a really big refund. Make $10,000 more the following year, and all of sudden you may owe a lot. It’s hard to explain, but it happens, especially when there’s self-employment involved. If the Earned Income Credit makes up a big portion of your tax refund, make sure you understand the rules.
- Selling a rental house. Unless the property has decreased in value, you typically have to pay back any depreciation you’ve ever claimed on the house in the year of sale.
- Receiving spousal support. Spousal support is taxable income!