Talking Taxes: These are the top reasons taxpayers owed the IRS

Tuesday , May 16, 2017 - 7:50 AM

TRACY BUNNER, Talking Taxes columnist

This tax season, I came across two frequent situations in which taxpayers owed the IRS. Each of these situations can be avoided if the taxpayers will make changes throughout the year.

Situation No. 1: Taking money from your retirement fund

Taking money from a retirement fund often makes a taxpayer owe when the tax return is filed. If the taxpayer is under the age of 59 1/2, there is a penalty of 10 percent of the amount withdrawn, which is added to the tax liability.

Many taxpayers don’t have any taxes or very little taxes withheld from the amount withdrawn from the retirement fund. Proper planning can help to avoid owing taxes at the end of the year.

RELATED: Talking Taxes: Why you should file your tax return, even if it's three years late

When a taxpayer withdraws from a retirement fund several things need to be consider. How will this additional income affect the return? The age of the taxpayer at the time the funds are withdrawn. Are enough taxes withheld from the withdrawal?

Most retirement funds are tax-deferred. Funds such as a 401k, Thrift Savings Accounts or IRAs are tax-deferred. Tax-deferred means that the taxpayer will pay the taxes when the money is withdrawn.

If the retirement fund is created through a taxpayer’s workplace, the amount of income reported on the W-2 is reduced by the amount of money contributed to the taxpayer’s retirement fund. This can be seen on the W-2 when Box 1 is lower than Box 3, and there is usually an amount reported with a Code D in Box 12 of the W-2.

If a taxpayer contributes to an IRA outside of the workplace, an adjustment occurs on the tax return that reduces the taxpayer’s income before it is taxed. Again, deferring the tax until withdrawn from the retirement account.

Once money is withdrawn from a deferred retirement account, this income is added to all of the other income on the tax return. The additional income could place the taxpayer into a higher tax bracket in which not enough taxes were taken out of wages and other income on the return.

If the taxpayer is under the age of 59 1/2 when the funds were withdrawn, an additional tax of 10 percent is assessed, which is called a penalty. This penalty is added to the actual tax liability and can only be reduced by the amount of taxes withheld from all income.

A lot of taxpayers this tax season didn’t consider the higher tax bracket or the penalty when determining the amount of taxes to withhold from the funds withdrawn.

The most frequent reason was that the person the taxpayer spoke to when requesting a withdrawal said to withhold 20 percent when asked how much should the taxpayer take out of the withdrawal. This amount would be fine if the taxpayer is in the 10 percent tax bracket.

However, most taxpayers are in the 15-25 percent tax bracket, meaning that the 20 percent withheld is short of meeting the taxpayer’s tax liability and the additional penalty.

If a taxpayer must withdraw money from a retirement account, calculate if this additional money will put the taxpayer into a higher tax bracket and if the taxpayer’s age will result in an additional penalty.

For example, if the taxpayer is in the 15 percent tax bracket before the withdrawal and the additional money puts them into the next tax bracket of 25 percent and the taxpayer is under 59 1/2, the taxpayer should have at a minimum 35 percent taken out of the amount withdrawn. This will cover the additional income added to the return.

However, the taxpayer still may owe if the regular income does not have the correct amount of taxes withheld.

Situation No. 2: Not taking out enough taxes on your income

One of the most frustrating things for a tax preparer is trying to explain that the amount of taxes withheld from wages is not adequate to cover the taxes assessed on a taxpayer’s taxable income.

The W-4 is a very confusing form. The simplest way to figure the amount of taxes to be withheld from each paycheck is to make a fist to represent the filing status (single, married filing jointly or married filing separate) and only add a number if there are dependents (children for example) in the household.

If there are no dependents, the taxpayer should put single and zero, or married and zero on the W-4. This will usually cover any tax liability on the income. If the taxpayer is able to itemize, this will help reduce the taxable income in case the taxpayer put a number after the filing status.

One of the most frequent tax errors to occur this season was when a single or married taxpayer added a number after the filing status when there was not a dependent in the home.

Each number added to the filing status on the W-4 means that there will be a reduction in the taxable income of the exemption amount. For 2016 the exemption amount was $4,050.

Depending on the tax bracket of the taxpayer without dependents the exemption amount meant that $405 (10 percent), $608 (15 percent), $1,013 (25 percent), etc. of taxes were not withheld from the paycheck, resulting in owing the IRS.

These two situations caused many taxpayers to owe this season. Planning throughout the year can help resolve these problems.

Tracy Bunner is an enrolled agent and tax preparer in Harrisville. She can be reached at 801-686-1995 or at tracy.bunner@hrblock.com.

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