Surprises can be fun and exciting, but not when it comes to taxes! An unexpected hefty tax bill can be stressful! If you or a family member have ever received an unexpected tax bill, due to annual income tax filing, you probably want to make sure that it never happens again.
Even a hefty refund from the IRS can mean that you have not benefitted from having that extra cash in your pocket throughout the year. You may be able to contribute less tax throughout the year, increasing your take-home pay throughout the year, which could be helpful to have more money available.
To avoid large refunds or liabilities when filing your annual income tax return, it is vital to develop a basic understanding of the calculation of income tax.
How is income tax calculated?
Most United States workers find gathering supporting documentation for income tax returns to be a daunting task, with many filers procrastinating until April deadlines to file.
If you are like many Americans, you have a basic understanding of the filing process, but the understanding of how the calculations work and the results to be a big mystery.
Most people fall into one of two categories upon receiving results of their annual filing:
- They are receiving an income tax refund and are likely delighted with the “good news.” The filer begins making plans to spend some of this money, perhaps on a fun vacation or pay off a lingering bill.
- They are writing a check to the IRS and perhaps a state or local entity and are somewhat irritated because you would be pressed to find someone who likes to pay more money in taxes!
What is involved that some owe the IRS, and some receive a refund?
Let us look at an example:
Jane Dixon at ABC company earns $40,200 in the previous year.
Sally Johnson at ABC company earns $40,200.
Jane receives a $500 refund from the IRS.
Sally owes the IRS $500 due to an underpayment.
The two co-workers learn of each other’s situation over their lunch break.
Sally becomes upset with her company because she thinks they did something wrong. Why else would her co-worker that has the same earnings yield a refund, and she OWE the IRS?
Let us continue…
Income tax is a pay as you go tax.
The withholdings are calculated based upon the W-4 documentation provided by the employee to the employer during the onboarding process with regards to applicable dependents and marital status claimed or documented on the form.
During the annual filing, a calculation occurs based upon the previous year’s wages and respective income tax brackets (percentage). Adjustments are made for tax credits and deductions—a final calculation results in the filer’s liability. The taxes withheld from the previous year’s wages indicated on the W-2 is subtracted from the calculated liability. An overpayment or underpayment is easily identified from this equation.
2020 Federal Income Tax Brackets
| Tax rate | Single | Married, filing jointly | Married, filing separately | Head of household |
| 10% | $0 to $9,875 | $0 to $19,750 | $0 to $9,875 | $0 to $14,100 |
| 12% | $9,876 to $40,125 | $19,751 to $80,250 | $9,876 to $40,125 | $14,101 to $53,700 |
| 22% | $40,126 to $85,525 | $80,251 to $171,050 | $40,126 to $85,525 | $53,701 to $85,500 |
| 24% | $85,526 to $163,300 | $171,051 to $326,600 | $85,526 to $163,300 | $85,501 to $163,300 |
| 32% | $163,301 to $207,350 | $326,601 to $414,700 | $163,301 to $207,350 | $163,301 to $207,350 |
| 35% | $207,351 to $518,400 | $414,701 to $622,050 | $207,351 to $311,025 | $207,351 to $518,400 |
| 37% | $518,401 or more | $622,051 or more | $311,026 or more | $518,401 or more |
A tax refund is not extra funds received from the federal government. It is a refund for the overpayments that you made throughout the previous year based upon your overall liability.
Likewise, a tax bill is not a penalty. It is merely the money owed because of the underpayment contributions throughout the previous year, based upon your liability, which includes your income less any tax deductions and applicable credits.
Back to our example:
Jane’s liability based upon her income and personal situation is $6,500 and has contributed $7,000 throughout the year she then RECEIVES a $500 refund due to her OVERPAYMENT.
Sally’s liability is based upon her income, and her personal situation is $6,500 and has contributed $6,000 throughout the year; she then has a LIABILITY of $500 due to her UNDERPAYMENT.
The two co-workers may have different situations, which could include a different 401K contribution amount, different number of dependents, or applicable tax credits.
Both Earned Income and Unearned Income will impact your tax liability.
Earned Income includes:
- Wages
- Bonuses
Unearned Income includes:
- Interest
- Dividends
- Profits on investments
- Pensions and some other retirement benefits
- Alimony
What factors can reduce your tax liability?
How many dependents an employee claims, marital status (and spousal income), tax deductions, and tax credits are all factors that might affect tax liability.
A tax credit is a dollar for dollar match. For example, if Jane had a liability of $6,500 and received a $500 tax credit, then her responsibility would be reduced to a full $500. Calculate how much was paid as she earned income in the previous year combined with the tax credit, and you will see this is how she received a refund as opposed to her co-workers.
Tax credits may include:
- New dependent
- College and college tax credits
- Earned income tax credit
A tax deduction is not a dollar for dollar deduction from liability. Deductions may include mileage for business trips and mortgage interest.
If your situation has remained unchanged from the previous year, your income tax liability, is unlikely to change too much. However, the Federal Government regularly makes changes that may impact your debt (including changes in income tax brackets, applicable deductions, and applicable tax credits).
If you have had a significant life change such as adoption, childbirth, a dependent in college, and 1099 income from self-employment, or purchasing or selling a home; you may want to take your most recent paycheck stub and perform a paycheck audit on the IRS website utilizing the IRS Tax Withholding Estimator.
The IRS Tax Withholding Estimator is a very user-friendly tool asking a few basic questions.
The online calculator also takes into additional considerations that impact an individual and family expected contribution, based upon their unique situation, which includes:
- Earned Income Tax Credits
- Daycare Credits
- College Tax Credits
- Child Tax Credits
For those that are already receiving social security payments, the calculator will consider this.
What about those who are self-employed?
The IRS Tax Withholding Estimator is not recommended for the self-employed. Self-employed individuals are typically required to make quarterly tax payments based upon projected earnings, past tax returns, income bracket, type of business entity, and personal deductions.
More information on estimates can be found at the IRS website:
An estimated tax is the method used to pay tax on income that is not subject to withholding (for example, earnings from self-employment, interest, dividends, rents, alimony, etc.).
Besides, if you do not elect voluntary withholding, you should make estimated tax payments on other taxable income, such as unemployment compensation and the taxable part of your social security benefits.
Adjustments to Lower Your Liability
An employee can adjust amounts on the calculator for 401(K) contributions to see how increasing contributions could potentially reduce the amount of income tax owed. Based upon the information that is input in the online calculator, it will tell you if you are expected to receive a refund or owe additional taxes.
You can use the IRS Tax Withholding Estimator to understand the overall impact of updated a W-4 form to change withholdings. Your Human Resources representative or Payroll Administrator can amend your W-4 to adjust deductions and perhaps pay a little throughout the remainder of the year to avoid a substantial liability or overpayment.
NOTE: This calculator is for estimating Federal Taxes only. Local and state taxes would be unique to your state and local taxes. You may contact your respected regulatory entities concerning income tax guidelines. Federal income tax represents your most significant tax obligation.
PaySmart is a payroll provider located in Mechanicsburg, Pennsylvania, supporting small businesses in the Central PA region. PaySmart is dedicated to helping small businesses take care of their payroll needs. To learn more information about how PaySmart may provide payroll solutions, please contact 717-766-1777. Our New Client Concierge is waiting for you.