Although anyone may find him- or herself owing a significant amount of money to the IRS due to back taxes, there are some instances that make you more susceptible to having a tax bill that you cannot pay. Once you find yourself unable to pay the one bill, it may quickly spiral until you have a massive bill and face a lien or levy on your wages or assets, putting you into an even bigger financial hole.
To prevent this from happening, it is important to recognize the biggest risk factors for large tax bills and learn ways to reduce the chance that you will end up with one. Below are four of the most common situations that leave people with an unexpected tax bill that may just become the trigger for larger problems.
Contract workers are one of the groups of taxpayers most at risk of owing the IRS money. Unlike employees, contract workers do not have their taxes taken out at every paycheck. This means it is up to them to save throughout the year so they can pay the bill on Tax Day. They also may have to pay estimated taxes when applicable.
However, many contract workers, especially those who are just starting out and do not realize the tax implications of their employment status, do not efficiently and correctly handle the accounting. Then, come tax time, they owe taxes but do not have enough savings to cover the amount. Some may take out a private loan or use a credit card to cover it, but some may just not pay. This may continue for several years in a row until all of a sudden you are drowning in debt, especially when you add on the penalty fees and interest. You may also have a penalty for not paying estimated taxes throughout the year that only adds to the total you owe.
How can you fix this? The best way to avoid a tax burden as a contract worker is to take out money with every paycheck specifically to pay your taxes. You can put it into a special bank account reserved for this purpose. Pay quarterly estimated taxes, especially if required. You may find that you end up with a refund come tax day if you overpay your estimated taxes.
If you can afford it, it may be beneficial to work with an accountant or tax preparer to get you started with properly accounting for your taxes with every paycheck. It may cost you money upfront, but it will save you in the end by ensuring you remain compliant with your taxes. If you or your spouse has a full-time job where taxes are withheld, you can also increase the tax withholding on that job to help balance what is owed for your contract work.
Self-Employed and Small Business Owners
Similar to contract employees, those who are self-employed or own a small business are at risk of having a huge tax bill come tax day, which can easily snowball into an ever-growing debt with penalties and interest.
Like contract employees, self-employed individuals, and small business owners, especially those whose business is treated as a disregarded entity, are expected to pay taxes on their income. For self-employed individuals, this also includes self-employment tax on top of income tax, which may increase your burden, especially as some deductions do not apply to self-employment tax. You also must pay estimated taxes throughout the year if you make above a certain amount of money. If you do not pay these throughout the year, you may have to pay a penalty come tax day, even if you are able to pay the taxes you owe.
Small business owners and self-employed individuals are also those at the most risk of an audit. You may deduct certain expenses or take credits or deductions that you believe are valid, only to find out during an audit they are not, leaving you with a tax bill.
As with contract employees, the best way for the self-employed and small business owners to avoid trouble with the IRS is to set up a strong accounting system throughout the year where you save money to pay taxes and file estimated quarterly taxes when applicable. You can set this up yourself, or if accounting is not your forte, then work with a professional accountant or bookkeeper. Come tax day, have a professional tax preparer review your tax return to ensure that you accurately take deductions and credits so that there will be no surprises if you end up with an audit.
Not Withholding the Right Amount on Your Paycheck
Those who are full-time employees may also find themselves at risk of large tax debt if they have filled out the wrong withholdings on their W4 form. If you take out too little tax on every paycheck, then when you file your tax return, you will have an unexpected surprise at the amount of money you owe. Depending on your salary and assets, this could end up being a significant amount of money, and you may also be penalized for underpaying your taxes. You may find yourself quickly drowning in debt looking for a way out, especially if you let this go on for more than one year.
The best way to fix this is to check to make sure that you take out the correct withholdings on your paycheck. Conduct a paycheck checkup every few years, and ensure that you update any time you have a major life change, such as a marriage or the birth of your children.
Change in Financial Circumstances
Another reason that you may end up owing tax debt is a change in financial circumstances, whether for good or for worse. Perhaps you had a good-paying job but lost it. If you do not prepare properly, you may end up owing a large amount of taxes that you can no longer afford due to the partial year of income. When you sell assets, such as real estate, you also will need to pay taxes on its value. Those who have rental properties may also find that they do not properly handle the taxes. If you win a large prize, such as the lottery or sweepstakes, you also need to pay the taxes on it. Some large gifts above a certain amount may also need to be taxed. The best thing to do is talk with a tax professional or accountant about any major financial changes to ensure that you are left with no big surprises down the line.
There are many other reasons why people may end up with a large tax bill, but these are some of the most common situations that leave people in debt. If you already have a tax bill that you have no idea how you will afford to pay, then contact Fidelity Tax Relief. Our tax professionals will review your situation to see if you qualify for one of the IRS’ Fresh Start Initiatives, such as an Offer in Compromise, Installment Agreement, Penalty Abatement, Currently Not Collectible and Innocent Spouse Relief.