In an ideal world, there'd be a perfect system in place to ensure that you're paying exactly the right amount of taxes year after year. There'd be no such thing as getting a tax refund (which is essentially akin to giving the government a tax-free loan), nor would you have to deal with the stress of owing money come tax time.
Unfortunately, the tax system just doesn't work that way. There are numerous factors that come together to determine your ultimate tax liability, and too often, it isn't until you actually sit down and complete your return that you get a clear picture of whether you'll owe money to the IRS or get some back in return. But if you want to know whether you'll be looking at writing a check this year, ask yourself these questions:
Am I claiming the right number of allowances on my W-4?
Your W-4 tells your employer how much tax to withhold from your regular salary. Each allowance you claim will reduce the amount of tax withheld from each paycheck, but if you claim too many, you could end up owing the IRS some serious money. You're allowed to claim an allowance for yourself, your spouse if he or she isn't working, and any dependents you have.
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If you're single with no kids, it's pretty straightforward. But if you're married with children, you'll need to make sure you're not claiming too many allowances between the two of you. If, for example, you have a child and you each claim that child as an allowance, you could up owing some money down the line.
Do I have a lot of outside income?
Even if you get those allowances just right, the taxes your employer withholds are based on your job-related earnings only. If you have additional sources of income, whether it's a side business, investments, or a savings account, you may wind up owing taxes by virtue of that alone. Imagine, for example, that you earn $400 a year in interest from your bank. If your ordinary income tax rate is 25%, you'll owe $100 of that $400 to the IRS. Now that won't necessarily result in a net underpayment of taxes for the year, but consider it fair warning that you may wind up writing a check.
Am I eligible for a large number of deductions or credits?
Tax deductions work by exempting a portion of your income from taxes, while credits work by reducing your tax liability in the exact amounts they're worth. In other words, a $1,000 tax deduction means you won't pay taxes on $1,000 of your income, but if your effective tax rate is 25%, that's only a $250 savings. A $1,000 tax credit, on the other hand, will knock $1,000 directly off your tax bill. Because both are valuable tax savings tools, it pays to pursue as many as possible.
If you're a homeowner, you can deduct expenses such as mortgage interest, property taxes, and PMI premiums. If you spend a lot of money on healthcare, you might qualify for a medical expense deduction. And any time you donate cash or goods to a registered charity, you can take a deduction for your contribution.
Tax credits tend to be more restrictive than deductions, but if you're a student or pay for one to go to college, you might look into options such as the American Opportunity Tax Credit or the Lifetime Learning Credit. If you're a low earner, you may be eligible for the Earned Income Tax Credit. And if you have children, you might qualify for the Child Tax Credit or the Child and Dependent Care Credit. Most of these credits aren't mutually exclusive, so the more you can snag, the less likely you'll be to owe the IRS money.
Crunch those numbers ahead of time
Since it can be difficult to determine whether you'll owe taxes until you actually sit down to run the numbers, it's important to start working on your return well before this year's April 18 deadline. The reason? If you do owe taxes this year, and you don't have that money available in your savings account, you'll need time to come up with a plan. Otherwise, you'll face a late payment penalty even if you file an extension.
Finally, try not to get discouraged if it turns out you owe the IRS a little bit extra this year. All it means is that you got to use that money earlier, while the IRS didn't. And that's not a terrible deal at all.
