Each year I talk with many people about their tax situations. With most of my returning clients we work on a plan during the year to make sure that they don’t owe a large sum of tax; at least not a large unexpected amount of tax. The goal is to have them owe a small sum (hopefully less than $1,000) or have a small refund.
So, what happens when you get the unexpected surprise and you owe more than you have the funds to pay the balance due all at once. Well the first thing I would tell you is DON’T IGNORE IT! It will only get worse if you do.
I want to give some examples of what could cause that type of situation in the first place so hopefully you can keep this from happening to you.
•You received a large retirement distribution either from your account or from one you received from a deceased relative. This only gets worse if you are also subject to the 10 percent early withdrawal penalty because you are under 59½ and/or you did not have any or enough federal withholding taken from the distribution. I usually suggest that you withhold at least 20 percent from each distribution, but it generally depends on your income tax bracket.
•You left an employer in which you had a 401(k) loan outstanding and did not pay it all back before you left. This becomes a taxable distribution (potentially subject to the 10 percent penalty as well) for the amount you do not pay back. You need to make sure that you pay a little extra federal withholding somewhere else or make an estimated payment.
•You start a new business as a sole proprietor (such as a Realtor, consultant, or construction contractor, etc.) where you have a large income, a small amount of expenses to offset that income and you made no estimated payments or have very little federal withholding. I usually recommend that you withhold at least 30 percent of your gross income (that is your income before expenses) and remit this to the IRS as an estimated payment.
•You have a separate entity such as a partnership or S corporation in which you conduct your business and there is a large pass-through income (larger than usual) that is above and beyond the W-2 wage that you are taking. You have not made any or little estimated payments or insufficient federal withholding. This where a mid-year and end-of-year tax planning session will help you to minimize the cash flow effect.
•You have large capital gain income (especially if it is mostly short-term gains) from the sale of stocks, bonds, and mutual funds. Additionally, you can also have large interest and dividends without making estimated payments or having sufficient federal withholding. If you have long-term gains and/or qualified dividends and find yourself in the 10 percent or 15 percent income tax bracket you will be fortunate enough to pay a long-term capital gains rate of zero (at least to the extent that gains do not throw you into the 25% tax bracket).
• You have a large amount of Social Security income and your other income makes this income taxable to the maximum 85 percent limit. You also have no federal withholding taken from this income. Yes, you can file Form W-4P with the SSA and have federal withholding taken from your benefit payments.
•You have a large pension distribution from the military or the company you worked for over 30 years and you have a low amount of federal withholding deducted from your distributions. Depending on your tax bracket, I recommend withholding at least 10 percent-15 percent from your retirement distributions.
•Your divorce was finalized in the year, you now file as single, you receive a large sum of alimony that has no federal withholding. Make sure you remit estimated payments of at least 20 percent of the income depending on your income tax bracket.
•Your child is no longer in college and you can no longer claim them as a dependent and there are no more education credits available. You probably have been getting a nice reduction in your tax the last few years, but now your tax will be much higher. Make sure you take some extra federal withholding to help offset. You can do this by filing a new Form W-4 with your employer.
The moral to the above stories is to make your estimated payments during the year or have extra federal withholding taken in order to reduce the year-end tax liability. But if you still find yourself way short, don’t fret. You can try to borrow against some assets or from a friend or family member (although this last one is not the most recommended. At least if you want to continue to have a good relationship).
You can try to sell something to raise the cash, but be careful as this could make a new taxable event in the following year. It is not recommended to take the money out of a retirement plan as this will cause future pain in the form of taxes and early withdrawal penalty.
Finally, you can call the IRS to set up a payment plan called an Installment Agreement. If you face the issue head on with them, they are very accommodating.
At the end of the day, you should always consult a tax professional that is experienced in dealing with the IRS.
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