Taxes might be the last thing on your mind as 2023 comes to a close. But preparing in advance can make Tax Day less of a chore, especially if you aren't sure whether you're getting a tax refund or a tax bill from the IRS.
There are several reasons why you might owe money to the IRS: if you're self-employed, if you withdrew from a retirement account or if you no longer qualify for certain tax credits, to name a few. Preparing ahead of time can help you minimize the hit.
"Your federal income tax return is simply your single largest financial transaction every year," said Mark Steber, chief tax information officer at Jackson Hewitt. "And it pays off to develop some good habits now."
The 2024 tax filing season starts in less than a month, so now's the time to come up with a game plan, especially if you think you might owe the IRS. Even though you can file your tax return in late January, your payment isn't due until April 15, 2024.
What is my tax liability?
If someone refers to your "tax liability," it can sound rather intimidating. It refers to the total amount of money you owe the IRS for combined taxes -- income tax, capital gains tax, self-employment tax, past-due taxes, sales tax, etc. While your tax liability is determined by your earnings and filing status, you can reduce the amount you owe the federal and state government by taking advantage of certain deductions and credits.
If you're worried about your tax liability, the most important thing to do is to file your tax return sooner rather than later. Filing early lets you know exactly what you'll owe, even though you won't have to actually submit your payment until tax day. "Get your calculations done and file early so you have three or so months to figure out how to arrange for that money," Steber said. Your balance isn't due to the IRS until midnight on April 15, 2024.
Why would I owe money to the IRS in 2024?
There are several reasons why you might owe money to the IRS. If you fall under one of the following categories, here's what you need to know so you can start saving now:
1. Your income changed in 2023
When your income increases, so do your taxes. If you got a raise at work or started a new job with a higher salary, you could fall into a higher income tax bracket, thereby increasing your tax bill. Likewise, if you made extra income from a side gig, you'll have to pay taxes on that extra cash.
"If you make more income, you're going to owe money," Steber said. If you didn't pay estimated taxes or have enough withheld on your W-4, that could mean you didn't pay enough taxes on that money throughout the year, he added.
2. You changed the withholding status on your W-4
Your withholding amount is the income tax your employer takes from your paycheck and gives to the IRS on your behalf. Withholding too little on your W-4 can lead to a higher tax bill, while withholding too much can result in a tax refund.
You can check your withholding status and make changes at any time. But keep in mind that not paying enough estimated tax on your income (under-withholding) can trigger an underpayment penalty from the IRS.
3. You're a freelancer
If you did any freelance work this year, even on a part-time basis, the IRS considers you self-employed and requires you to file taxes as a business owner. You're responsible for filing standard income taxes based on your tax bracket and a self-employment tax rate of 15.3% for Social Security and Medicare. Every job that pays you $600 or more should provide you with a 1099-MISC form, which you'll need when you file your tax return.
If you expect to owe more than $1,000 in taxes, you must pay estimated taxes throughout the year, at least every quarter.
4. You're a small business owner or independent contractor
If you're a small business owner, you'll need to pay quarterly estimated taxes to avoid a big tax bill. If your income is steady throughout the year, calculate your annual income minus deductions to figure out what you'll owe in taxes, then split that into four equal payments. If your income fluctuates during the year, you can adjust your quarterly payments. Any overestimation or underestimation can be corrected in the next payment cycle.
5. You made a withdrawal from your retirement account
Tax-advantaged retirement plans, such as an IRA or 401(k), are subject to an additional 10% income tax penalty if you withdraw any amount before the age of 59½. There are several exceptions that allow for penalty-free withdrawals, but you still have to pay taxes on that income.
6. You collected unemployment
If you received unemployment benefits this year, that income is considered taxable. You can choose to have taxes withheld from your unemployment check so you aren't hit with a bill once you file your return in spring. But that's up to you. If you want to pay taxes on your unemployment checks, you need to fill out a W-4V form or pay quarterly estimated tax payments.
7. You moved states
When you move to a new state, you'll likely have to file a part-year resident return in the state you moved from and the state you moved to, which could end up increasing your tax bill. Every state has its own rules and regulations, so make sure you understand the fine print before filing.
8. You changed your FSA or HSA contributions
Flexible Spending Accounts and Health Savings Accounts are tax-advantaged accounts that allow you to set aside money before it's been taxed to pay for qualified out-of-pocket medical expenses. If you recently reduced the amount you contribute to one of those accounts, that will increase your taxable income, i.e., your payroll tax bill.
9. You no longer qualify for tax credits
Tax credits reduce the amount of income tax you owe dollar-for-dollar. Unlike deductions and exemptions, tax credits are designed to reward behaviors considered beneficial to the economy, such as investing in renewable energy or solar panels for your home. But if you no longer qualify for one or the IRS denies your claim for a credit, you might need to pay back the claims (plus interest).
How much should I save for taxes in advance?
Some experts suggest saving 15% to 30% of your profits as a good rule of thumb, but the amount of money you should save for taxes depends on your filing status and taxable income.
"The W-4 has become more complicated than it ever has been," said David Blaylock, head of advice and regulatory compliance at Origin. "But at the same time, there's also some pretty robust tooling available online that can really help you figure out what you might owe from a tax liability standpoint."
You can get a good idea of your expected tax liability by plugging some personal details into an online tax calculator. You'll need to include your estimated income, number of dependents, federal withholdings, credits and deductions, and so on. The IRA also offers a tax withholding estimator that can help you determine how to complete your W-4 if you have too much or too little federal income tax withheld from your paycheck.
Where should I put the money I've saved for my tax bill?
You don't have to keep the money reserved for your tax bill in a separate bank account, but it can help you keep track of your savings. Plus, since the best high-yield savings accounts are offering high interest rates with yields over 5%, transferring your tax savings into an HYSA could pay off.
High-yield savings accounts are ideal for short-term savings goals, allowing for quick access to withdraw and deposit money. You can set up automatic transfers from your checking account, streamlining your contributions so you don't have to think about it later.
What if I already paid estimated taxes?
If your taxable income isn't subject to federal withholding (meaning you don't have a W-4 with an employer or aren't withholding enough), you're generally required to make estimated tax payments at least four times a year. This applies to anyone who would owe the IRS $1,000 or more when their return is filed.
In 2023, quarterly tax payments were due on April 18, June 14 and Sept. 15. The final payment for the 2023 tax year is due by Jan. 16, 2024. If you're caught up on your estimated taxes, you should have a smaller tax bill or no tax bill in the spring. If you don't pay enough estimated taxes throughout the year, the IRS can charge you late penalties.
What if I didn't save enough to pay my tax bill?
Saving money for anything is hard these days. But having enough funds to pay the IRS when the time comes isn't an optional expense. "If you can't afford to pay your tax bill, the worst thing you can do is just ignore it," Steber said. The good news is that the IRS has several payment plans available so you can pay over time, Steber added.
If you can't pay your taxes, lean on a payment alternative to avoid accruing additional interest and penalties. You can approach this one of three ways:
Ask for a monthly installment plan: After you file your tax return, fill out a payment agreement application. You'll qualify for a long-term payment plan (monthly installments) or a short-term payment plan (paying in 180 days or less), depending on your specific tax situation. Payment plans will accrue interest like any loan. This option is available only if you're in good standing with the IRS, meaning you've filed all past-due tax returns.
Settle your tax debt with the IRS: If you don't have the money to pay your tax bill, you can settle your tax debt with the IRS by requesting an offer in compromise. This allows you to settle your debt for less than what you owe. The IRS determines your eligibility based on your ability to pay, income, expenses and asset equity. The IRS generally approves an offer in compromise if the amount you offer is the most they can expect to collect within a reasonable time period.
File and make partial payments: The worst thing you can do is not file your taxes. At the bare minimum, file your taxes and make a partial payment. The failure-to-file penalty is usually 5% of the monthly tax owed (up to 25%), while the failure-to-pay penalty is 0.5%.
How can I make sure to get a tax refund next year?
The IRS issued more than 237.8 million refunds last year, adding up to nearly $512 billion, according to the Internal Revenue Service 2022 Data Book. But to make sure you receive a tax refund next year, you need to maximize all possible deductions you're eligible for. "You want to look for opportunities to really maximize the amount and reduce your tax burden," Blaylock said.
As your circ*mstances change, it's important to update your W-4, which you can do throughout the year."A lot of people think that your W-4 is a set it and forget it type thing, but it's really not," Blaylock added. You may find that you need to do some additional withholding from your paycheck to make sure you're not stuck with a tax bill.
Once you secure a tax refund, take advantage of jump-starting your emergency savings. "A lot of people don't have an emergency fund or maybe have an insufficient one, so your tax refund can really be a windfall that could help you toward that goal," Blaylock said.
