Why Do I Owe Federal Taxes on My W2?
Confused by a tax bill as a W-2 employee? Learn how your paycheck withholding is determined and how to better align it with your actual annual tax liability.
It is a common occurrence to owe federal taxes after receiving your Form W-2. The U.S. tax system operates on a pay-as-you-go basis, meaning you pay taxes throughout the year as you earn income. The total tax withheld from your paychecks, however, may not always align with your total tax liability calculated at the end of the year.
The Role of Form W-4 in Tax Withholding
The primary instrument that dictates how much federal income tax your employer withholds is Form W-4, the Employee’s Withholding Certificate. When you begin a new job, you complete this form to provide your employer with information about your financial situation. This includes your filing status, the number of dependents you will claim, and any other adjustments for additional income, deductions, or credits you anticipate. Your employer’s payroll system uses these inputs to calculate the tax to set aside from each payment.
At the end of the year, your employer sends you a Form W-2, Wage and Tax Statement. This document summarizes your total earnings and the total federal income tax that was withheld. When you file your tax return, you calculate your actual tax liability based on your total income, deductions, and credits. If the tax withheld on your W-2 is less than your calculated tax liability, you will owe the difference to the IRS.
The Internal Revenue Service (IRS) redesigned Form W-4 in 2020 to improve withholding accuracy. The new design uses a more direct, five-step process to account for your specific circumstances. It is a good practice to review your W-4 settings annually or whenever you experience a major life event to ensure your withholding remains accurate.
Common Reasons for a Tax Bill
A common reason for owing taxes is having multiple sources of income. If you hold more than one job, or if you are married and both spouses work, each employer’s payroll system calculates withholding in isolation. This can result in each job’s income being taxed at a lower rate than your combined income, leading to under-withholding. Form W-4 has a specific section to account for multiple jobs to prevent this.
Side Income
Income from freelance work, gig economy jobs, or a small business is another common reason for a tax bill. When you receive these payments, often reported on Form 1099-NEC, no taxes are automatically withheld. You are responsible for paying income and self-employment taxes on this income, and failing to make estimated tax payments throughout the year will likely result in owing taxes.
Supplemental Wages
Bonuses, commissions, and stock options are supplemental wages and may be taxed differently than regular pay. Employers can withhold a flat 22% on these wages. If your marginal tax rate is higher than 22%, this withholding may not be enough to cover the tax liability on that extra income.
Significant Non-Wage Income
Investment income, like capital gains or dividends, is not subject to payroll withholding. If you have income from these sources, you are expected to make estimated tax payments during the year. Forgetting to account for this income can lead to a tax liability when you file.
Changes in Life Circumstances
Major life events can alter your tax situation. Getting married or divorced changes your filing status, which affects your tax brackets and standard deduction. A child aging out of dependency can mean the loss of tax credits. If you do not update your Form W-4 to reflect these changes, your withholding will become inaccurate.
Incorrect W-4 Entries
Mistakes on your Form W-4 can lead to under-withholding. This includes selecting the wrong filing status, incorrectly claiming dependents, or overestimating deductions. For example, if you claim deductions on the W-4 but end up taking the standard deduction, your withholding will likely be too low.
Information Needed to Adjust Your Withholding
To accurately update your Form W-4, you need to gather specific financial documents. Start by collecting your most recent pay stubs for all jobs you hold, and if you file jointly, you will also need your spouse’s. These documents contain your year-to-date earnings and the amount of federal income tax that has been withheld so far, which is needed to estimate your total annual income.
Next, gather information on any other sources of income you expect to receive, such as from freelancing or investments. You can use the previous year’s forms like 1099-INT, 1099-DIV, or 1099-NEC as a guide for what to expect. This information is entered in Step 4(a) of the Form W-4.
Finally, you will need to estimate any deductions or tax credits you plan to claim. If you expect to itemize deductions, you will need estimates for expenses like mortgage interest and charitable contributions. For tax credits, you will need to know the number of qualifying children and other dependents to complete Step 3.
How to Submit a New Form W-4
Once you have determined how to fill out your Form W-4, you must submit it to your employer. Many employers have an online self-service portal where you can update your tax withholding information electronically. If your employer does not use an online system, you will need to submit a physical paper copy of the completed form, which can be downloaded from the IRS website.
Before you submit the form, it is a good idea to use the IRS’s Tax Withholding Estimator tool. This online calculator provides a precise recommendation on how to fill out your Form W-4 to meet your desired outcome, whether that’s a small refund or owing nothing. After submitting your new W-4, the changes will take effect within one to two pay cycles.