Essential Tax Budgeting: Avoiding Underpayments Made Easy

Recently, a planning client reached out to me in a panic, realizing he needed to dip into his investments to cover an unexpected tax bill. Upon reviewing his income tax return prepared by a third party, it became evident that he had under withheld federal taxes, particularly on his bonus income. This scenario is all too common during tax season, highlighting the significance of mastering tax budgeting to prevent such surprises.

Tax season often brings stress and confusion, as many individuals find themselves ill-prepared to settle their dues with the government. The root cause of this unpreparedness often lies in ineffective budgeting for income taxes throughout the year.

Budgeting for taxes extends beyond setting aside a portion of each paycheck. It requires a thorough understanding of one's financial landscape, including potential income sources and their corresponding tax obligations. Unfortunately, many taxpayers overlook crucial aspects of their finances, leading to underpayments and potential penalties from the IRS.

Here are some of the more common pitfalls I come across:

1. Misjudging Bonuses and Equity Compensation: Failure to factor in taxes on bonuses or equity compensation is a frequent mistake. These types of income often have different tax treatments than regular wages, potentially pushing individuals into higher tax brackets or resulting in insufficient tax withholding by employers. Companies will typically withhold only the minimum statutory rates which may not reflect your actual tax exposure.

2. Miscalculating Retirement Account Withdrawals: Withdrawing funds from retirement accounts like 401(k)s or traditional IRAs can lead to unexpected tax bills if adequate taxes aren't withheld. While these accounts offer tax-deferred growth, withdrawals are typically subject to income tax, necessitating careful planning to avoid surprises. Often no taxes are withheld because taxpayers don't realize to ask their financial advisors what they should do.

3. Neglecting Side Income and Gig Earnings: The rise of the gig economy means many individuals earn income from side hustles or freelance consulting work without upfront tax withholding. Failing to set aside a portion of this income for taxes can lead to higher-than-expected tax bills at filing time.

To correct underpayments and improve tax budgeting, consider the following steps:

1. Review Tax Withholding: Regularly review tax withholding to ensure it aligns with estimated tax liability. Significant life changes, such as salary increases or marriage, may necessitate adjustments to withholding to avoid underpayment.

2. Make Estimated Tax Payments: For income without tax withholding, such as bonuses or freelance earnings, consider making quarterly estimated tax payments. This helps evenly distribute tax liability throughout the year, mitigating the burden come tax time. The first payment is typically due April 15th which is the same date your personal income tax returns are due to be filed.

3. Utilize Tax-Advantaged Accounts: Take advantage of accounts like HSAs, FSAs, and retirement accounts to minimize taxable income. Contributions to these accounts can lower overall tax liability, providing significant savings.

4. Consult a Tax Professional: When in doubt, seek guidance from a qualified tax professional. They can offer tailored advice, navigate complex tax situations, and identify potential deductions and credits.

In conclusion, effective tax budgeting is crucial to avoid underpayments and associated penalties. By understanding income sources, adjusting withholding and payments, and leveraging tax-advantaged accounts, individuals can take control of their tax situation and ease the stress of tax season. Remember, proactive planning can lead to substantial savings and a smoother filing experience. If you don't properly plan you could be subject to underpayment penalties.

Tax-efficiently yours,

JG

Disclaimer:

The information provided above serves general purposes and should not be construed as professional advice. It is not exhaustive or applicable to specific situations. Reliance on this information is at your own risk, and it is recommended to consult a qualified tax professional for personalized advice. The views expressed are personal and do not reflect those of any specific organization.