Staying out of Debt with the IRS at Tax-Time
August 25th, 2006 Debt
Typically, your employer deducts or withholds income taxes from your paycheck based on the number of your deductions. The deductions reflect an estimate of what you’ll owe - but most people end up either paying something more to the IRS or getting a tax refund with money back.
You may have income not subject to withholding, such as dividends, interest, income from side businesses, tips, stock gains, gambling winnings, money paid to you as an independent contractor, small-business income, forgiven debts, hobby income, rents, and gifts above a certain dollar level. Because you haven’t paid out taxes from these streams of income, be sure that you prepare yourself for that inevitability.
As you do your planning, you can choose one of three approaches to what is called general tax-planning: Overpay, underpay, or strive to pay just the right amount. You can probably already guess which strategy is the right one (yes, the latter).
Overpaying your withholdings: Many people say that they deliberately overpay their taxes as a budgeting strategy: “I don’t want to owe any money” or “I use my refund to pay down my cards after holiday shopping.” The problem with overpaying is that, at a minimum, you’re giving the government an interest-free loan of your money - money that you could be using to pay down debt, build up savings, or achieve any of a zillion good purposes. If you’ve overpaid all year and an emergency comes along in November, you can’t ask the government for an advance of your refund to cover it. But you could use that money if you had it in a savings account, or even in a cookie jar. If you’re consistently getting a refund check every spring, talk to a qualified tax preparer and go over your situation. You’ll likely be able to find a way to cover your taxes (and not owe something on April 15), without overpaying along the way.
Underpaying your withholdings: If you don’t have a plan for your spending and savings, you may convince yourself that under-withholding your taxes provides the equivalent of an interest-free loan from the IRS. You tell yourself you’ll figure out the tax issue when it comes up, which is a really long time from now. Besides, you have pressing needs for the money, and they have to be taken care of immediately. The backup plan: If you owe money April 15, you can always pay it with your credit card, right? If you underpay your withholdings and owe a big tax bill in April, you’ll find that your credit cards will be absorbing more unplanned items than just taxes, and they might well be full already. A further caution about taxes of all kinds, is that under current bankruptcy rules, local, state, and federal taxes cannot be discharged in a bankruptcy, nor can credit card debt incurred from paying your taxes.
Paying the right amount of withholdings: Adjusting your withholdings so they mix perfectly with what you’ll owe at the end of the year is not as not as difficult as it may first seem. At least consult with a tax preparer to get a good forecast of your tax commitments for the year. You may get an early budget bonus if you find you’re over-withholding and can increase your deductions - which may allow you to fund some of those short-term goals you’ve been saving for. Conversely, if there is some shortfall in your future, you’re much better knowing about it in advance so you can do something before it shows up on your doorstep.