How Do I End Up Owing Taxes and What Can I Do to Avoid It?

Many people are surprised when they owe taxes instead of receiving a refund. This usually happens when not enough tax was withheld throughout the year or additional income sources weren’t accounted for properly. Understanding why this occurs can help prevent an unexpected bill.

Several common factors contribute to underpayment, from employment-related issues to investment gains and retirement withdrawals. Identifying these factors early allows for necessary adjustments before tax season.

Payroll Withholding Issues

Employees often assume their employer withholds the correct amount of taxes, but this isn’t always the case. Withholding is based on Form W-4, and errors on this form can lead to underpayment. Claiming too many allowances or failing to update the form after a salary increase can result in insufficient tax withholding.

Changes in tax laws also impact withholding. The IRS periodically adjusts tax brackets, deductions, and credits, which can alter the amount withheld. If employees don’t review their withholding annually, they may unknowingly underpay. The IRS provides a Tax Withholding Estimator tool, but many only use it after discovering they owe money.

Having multiple jobs or a dual-income household complicates withholding. If each employer withholds taxes as if the job is the only source of income, the total withheld may be too low. This is common when someone picks up a second job or when both spouses work. The IRS recommends using the W-4’s multiple jobs worksheet to adjust withholding, but many employees overlook this step.

Self-Employment Earnings

Self-employed individuals must handle their own tax payments, including income tax and self-employment tax, which covers Social Security and Medicare contributions. In 2024, the self-employment tax rate is 15.3%, with 12.4% allocated to Social Security (up to $168,600) and 2.9% for Medicare. Income over $200,000 for single filers ($250,000 for married couples filing jointly) is also subject to an additional 0.9% Medicare surtax.

Because taxes aren’t automatically deducted, self-employed individuals must make estimated tax payments quarterly—April 15, June 15, September 15, and January 15 of the following year. Failing to pay enough can result in underpayment penalties, which the IRS calculates based on the amount owed and the length of time the tax remains unpaid. The penalty rate fluctuates with interest rates.

Estimating taxable income can be difficult, especially for freelancers or business owners with fluctuating earnings. The safe harbor rule allows taxpayers to avoid penalties if they pay at least 90% of the current year’s tax liability or 100% of the previous year’s total tax (110% for high-income earners). This method helps prevent unexpected tax bills due to income spikes.

Capital Gains or Dividend Income

Investing in stocks, real estate, and other appreciating assets can create tax obligations. When an asset is sold for more than its purchase price, the profit is considered a capital gain. Short-term capital gains, from assets sold within a year, are taxed as ordinary income at rates ranging from 10% to 37% in 2024. Long-term capital gains, for assets held more than a year, are taxed at lower rates of 0%, 15%, or 20%, depending on taxable income. For example, single filers earning below $47,025 owe no long-term capital gains tax, while those earning over $518,900 pay 20%.

Dividend income is also taxable, with different rates depending on whether the dividends are qualified or nonqualified. Qualified dividends, typically from U.S. corporations and certain foreign companies, receive the same favorable tax treatment as long-term capital gains. Nonqualified dividends, often from REITs or money market funds, are taxed as ordinary income. For example, an investor in the 32% tax bracket would owe 32% on nonqualified dividends but only 15% on qualified ones.

Tax planning strategies can reduce investment-related taxes. Tax-loss harvesting involves selling underperforming investments to offset capital gains. Holding investments for more than a year before selling can lower tax rates. Placing dividend-paying stocks in tax-advantaged accounts like IRAs or 401(k)s can defer or eliminate taxes on earnings.

Retirement Distributions

Withdrawing from retirement accounts can increase tax liability, especially when required minimum distributions (RMDs) come into play. The SECURE 2.0 Act raised the RMD starting age to 73 in 2023 and will increase it to 75 by 2033. Failing to withdraw the correct amount results in a 25% excise tax, though this can be reduced to 10% if corrected in a timely manner. Unlike Roth IRAs, which grow tax-free, withdrawals from traditional IRAs and 401(k)s are taxed as ordinary income, potentially pushing retirees into a higher tax bracket.

Strategic withdrawals can help manage tax consequences. Spreading distributions over multiple years may prevent bracket creep. Qualified charitable distributions (QCDs) allow individuals 70½ or older to donate up to $100,000 directly from an IRA to a qualified charity, satisfying RMD requirements without increasing taxable income. Roth conversions, which transfer funds from a traditional IRA to a Roth IRA with taxes paid upfront, can reduce future taxable distributions.

Filing Status Adjustments

Changes in filing status impact tax liability. Life events such as marriage, divorce, or the death of a spouse alter tax brackets, deductions, and available credits, sometimes reducing the amount withheld or increasing taxable income.

Married couples who previously filed separately may switch to joint filing, often lowering their overall tax burden due to wider tax brackets and increased standard deductions. However, this can also increase taxable income if one spouse’s earnings push the couple into a higher bracket. Conversely, those transitioning from married filing jointly to single or head of household after a divorce may lose tax benefits such as dependent claims or certain deductions. Adjusting withholding or estimated payments in response to these changes can prevent underpayment.

For widows and widowers, the tax impact can be significant. The IRS allows surviving spouses to file jointly for the year of their spouse’s death, but in subsequent years, they may need to file as single or head of household, often resulting in a higher tax rate. This shift can be especially burdensome if the surviving spouse continues receiving income from pensions, Social Security, or investments. Reviewing withholding elections and estimated tax payments can help mitigate the financial impact.

Underpayment Penalties

Failing to pay enough tax throughout the year can result in penalties, even if the total amount owed is eventually paid by the filing deadline. The IRS imposes underpayment penalties when taxpayers don’t meet minimum payment requirements through withholding or estimated tax payments.

To avoid penalties, taxpayers must pay at least 90% of their current year’s tax liability or 100% of the previous year’s total tax (110% for those with adjusted gross income above $150,000). If these thresholds aren’t met, the IRS calculates penalties based on the amount underpaid and the number of days the balance remains outstanding. The penalty rate is tied to the federal short-term interest rate plus 3%, which fluctuates quarterly.

Taxpayers with irregular income, such as seasonal workers or those with significant investment gains, can use the annualized income installment method to adjust estimated payments based on actual earnings. This approach helps align payments with income fluctuations, reducing the risk of penalties. The IRS may also waive penalties for those who can demonstrate reasonable cause, such as financial hardship or a significant life event. Filing Form 2210 to request a waiver can provide relief in qualifying situations.