The last thing anybody wants come April 15 is an unexpectedly large tax bill. But if you didn't have enough money withheld from your paychecks or you didn't plan for certain activities that affect your taxable income, you might have an unpleasant surprise in store. Here's a look at five factors that could trigger unexpected taxes as well as strategies for planning around them.
1. Self-employment income. If you had income from freelance or consulting work and didn't have taxes withheld, your tax liability might catch you off-guard. Self-employed taxpayers are responsible for their own contributions to Medicare and Social Security, as well as the contributions that would have been made by an employer (also known as "self-employment tax"). When someone sets up a business, "they get this big shock when they owe self-employment taxes," says JeFreda Brown, CEO of Brown Accounting Solutions in Birmingham, Ala. One way to avoid this end-of-the-year surprise is to pay quarterly estimated taxes as money comes in so you don't spend the money in other ways. Taking deductions for eligible business expenses can help lower your tax bill, Brown adds.
2. Unemployment benefits. For some, it's a cruel irony that unemployment benefits are taxable. The American Recovery and Reinvestment Act exempted the first $2,400 of unemployment benefits from federal taxes, but that provision has since expired. One way to avoid a huge tax bill is to have federal taxes withheld from your unemployment checks (however, you may still owe state income tax) or set aside the money yourself so you'll have the money to pay taxes. "With a married couple, if one person goes on unemployment, maybe the working spouse would [increase] their withholding," says Neil Johnson, a partner in The Dolins Group, a financial planning firm in Northbrook, Ill. If you itemize deductions, you might also offset some taxes on unemployment benefits by deducting eligible job search expenses such as travel or lodging.
3. Forgiven debt. If you had debt forgiven by a credit card issuer, mortgage or student loan lender, or other financial institution, it may create "phantom income" that's taxable. Under the Mortgage Forgiveness Debt Relief Act of 2007, borrowers are exempt from taxes on forgiven mortgage debt (short sales, foreclosures or loan modifications) up to $2 million on a primary residence. This expired at the end of 2013, but Congress may still extend this tax relief. If your debt doesn't fall under MFDRA, don't despair. You may still be exempt from taxes if you fall under the Internal Revenue Service's insolvency exclusion -- meaning your debts surpass the value of your assets. "When people have forgiven debt, they shouldn't automatically think they're going to be taxed on that income," says Andrew Schwartz, founder and managing partner of accounting firm Schwartz & Schwartz in Woburn, Mass. "If somebody's debts exceed their assets, that 1099-C [the tax form for forgiven debt] isn't taxable."
4. Distributions from a retirement account. Withdraw money from a retirement account such as a 401(k) before age 59½, and you're typically subject to penalties and taxes. Some financial institutions will withhold federal taxes before distributing your money, but it may not be enough to cover your federal tax liability and you may still owe state income tax on distributions. "I see this snowball effect where you lose your job and you tap your IRA, but then you don't have the money to pay the tax," Johnson says. "Now you're dealing with the IRS on some sort of installment agreement." If you truly need the money in your retirement account, Schwartz suggests opting for a 401(k) loan if you're still with that employer and your plan allows it. "With a 401(k) loan, you don't pay taxes, and you pay yourself back plus interest," he says. "Another thing to do is to stop contributing to the 401(k) [temporarily]. That'll free up some cash flow."
5. Getting married. If you got married last year and you and your spouse both work, changing withholding status to married with two allowances may result in more taxes owed. That's because the withholding tables assume one spouse isn't working. "In a lot of cases, not nearly enough taxes are being taken out, and that's an unpleasant surprise for the newlywed," Schwartz says. "When somebody fills out [their withholding], single is one option or married, but withhold at the higher rate."
If you find yourself in a scenario where you owe tax money you don't have, ask your accountant about possible solutions. "We try to gauge when they'll be able to pay the taxes," Schwartz says. "If somebody can pay most of their taxes by April 15, we'll have that person go on extension." An extension must be filed by April 15 and generally gives you an extra six months to file your return. As long as you've paid 90 percent of that year's tax liability (or 100 percent of the previous year's tax liability), you can go on extension and only owe interest, no penalties, on the remaining 10 percent. Otherwise, you might need to work out an installment plan with the IRS, and consider whether you need to tweak your withholding or pay quarterly taxes going forward.
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