Understanding Why You Have A Tax Bill

Brandon R. Amaral, CFP®, EA
Brandon R. Amaral, CFP®, EA

Founder & Financial Planner, Amaral Financial Planning

There’s nothing more irritating than realizing you owe taxes to the IRS. Whether you’re preparing taxes yourself or working with a professional, you usually experience a similar process as the stages of grief:

  • Denial – “There must be a mistake in my data entry!”
  • Anger – “I already pay too much in taxes!”
  • Bargaining – “What if I get paid less, won’t I owe less taxes?”
  • Depression – “There’s absolutely nothing I can do to save on taxes.”
  • Acceptance – “I will always owe taxes in April.”

While these are very common feelings to have, there is a final step that you can take: Action. Before taking action, however, you must first be able to identify what is causing the tax bill.

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Here are common reasons you owe taxes in April:

Not withholding enough through payroll

Since the Tax Cuts and Jobs Act of 2017 (aka Trump’s tax plan), you might have noticed that you owe more in taxes each April. In an effort to address the new tax rates, the IRS changed the format of Form W-4, which is the form used to elect your allowances on your paychecks.

Compare the old Form W-4 (left) to the new Form W-4 (right) below:

For those who historically elected Married or multiple dependents, doing the same with the revised Forms W-4 may not be withholding enough taxes, and you might have another surprise tax bill next April. Working with an experienced tax planner can help you create a tax projection and recommend the appropriate payroll allowances for you.

Investments are tax-inefficient

If you’ve ever purchased investments from a broker or inherited an investment account from a family member, you may be familiar with a mutual fund. A mutual fund is a type of investment where your money is pooled with other investors so you can own a larger variety of stocks and bonds. These funds are managed by a portfolio manager who buys and sells on behalf of investors.

For most mutual funds, any time an underlying investment is sold at a profit, the taxable gains are passed on to investors (also known as a capital gains distribution). So while you haven’t sold stocks yourself and your portfolio hasn’t grown much, you could still end up paying taxes on these distributions. This characteristic causes mutual funds to be considered tax-inefficient investments.

You will find your capital gain distributions on line 2a of the Form 1099 you received from your bank or financial institution.

An alternative choice is to invest in Exchanged-Traded Funds (ETFs). ETFs are very similar to mutual funds in that they are highly diversified and track various market indexes. One popular difference is that ETFs rarely have capital gains distributions and are regarded as tax-efficient investments.

Not adjusting your cost basis

For individuals who receive equity compensation from their employer, you may need to be making manual adjustments when reporting your stock sales. This includes Restricted Stock Units (RSUs), Employer Stock Purchase Plans (ESPP), Incentive Stock Options (ISOs), and Non-Qualified Stock Options (NQSOs).

There are various factors that determine whether or not you will need to adjust your cost basis. One of the most common is having a zero-cost basis for your RSUs (on your Form 1099), however, the RSU income was already reported on your W-2. In this case, an adjustment to the cost basis is necessary to ensure that you are not “taxed twice”.

Not taking business deductions

From self-employed individuals to gig workers, you will likely receive a Form 1099-NEC. These forms are used to report Nonemployee Compensation received. This type of income will be reported on Schedule C of your tax return. Not only will it be subject to Federal and State taxes, you will also owe 15.4% in self-employment taxes.

Because of this, it is very important that you deduct all eligible business expenses to help you save on taxes. Depending on the nature of your work, this can include a portion of your mortgage/ rent payments, utilities, phone, internet, and auto expenses.

Understanding your tax bill will allow you to start taking proactive steps to save on taxes in the future. If you would like to work with a financial planner to walk you through your options, I would love to help you!

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Disclaimer: This blog is for informational purposes only, and should not be considered advice or recommendations. All opinions expressed herein are solely those of Amaral Financial Planning, LLC, unless otherwise specifically cited. Material presented is believed to be from reliable sources and no representations are made to another parties’ informational accuracy or completeness. You should consult your financial advisor, tax professional or legal counsel prior to implementation.