Underwithholding refers to a specific tax situation where an individual did not withhold a sufficient amount of taxes from their wages throughout the year to cover their tax liabilities.
Breaking Down Underwithholding
When an individual underwithholds, they have not set aside enough taxes from their income. Withholding, in general, involves portions of wages being deducted for federal, state, and local taxes. Tax calculations for withholding depend on the individual’s income, marital status, and choices related to dependents and filing status (single or joint filing).
Completing the Form W-4 Employee’s Withholding Certificate is how taxpayers inform their employer of their specific withholding preferences. Appropriately withholding taxes reduces the amount owed when filing the annual tax return. Conversely, insufficient withholding results in a balance that must be paid upon filing.
Avoiding Penalties
To avoid penalties for underwithholding, one must ensure at least 90% of the current year’s taxes or 100% of the previous year’s taxes are covered (whichever is lower). Additional criteria to avoid penalties include owing less than $1,000 in unpaid taxes or having no tax liability in the previous year.
Why Choose to Underwithhold?
Some individuals purposefully underwithhold taxes to use the extra funds throughout the year, perhaps for investment purposes. Profiting from such investments may lead to financial gains even after settling taxes owed. However, taxpayers should be cautious, as significant underwithholding can lead to penalties.
Submitting inaccurate information on the W-4 intended to reduce withholdings could potentially result in fraud charges.
Exploring Overwithholding and Its Benefits
On the contrary, overwithholding means withholding more than necessary, resulting in a tax refund after filing the return. Though receiving a refund can feel rewarding, overpaying essentially means providing the government with an interest-free loan.
By comprehending the implications of both underwithholding and overwithholding, taxpayers can make more informed decisions that best suit their financial goals and obligations.
Related Terms: tax filing, IRS, withholding allowances, tax return, income tax.
References
- Internal Revenue Service. “Tax Withholding for Individuals”.
- Internal Revenue Service. “Publication 505: Tax Witholding and Estimated Tax”, Pages 3-5.
- Internal Revenue Service. “Form W-4 Employee’s Withholding Certificate”, Page 2.
- Internal Revenue Service. “Topic No. 306 Penalty for Underpayment of Estimated Tax”.
- Internal Revenue Service. “Publication 505: Tax Witholding and Estimated Tax”, Pages 4, 22.
