April 10, 2024|By: Kari Brummond

Why Do I Owe Taxes This Year?

You finish your tax return and instead of a refund, you see a big bill. Why? Why do you owe taxes this year? The answer varies based on the situation, but to help you out, this post explains taxation in the United States. Then, it outlines common reasons that people end up owing on their returns and how to avoid facing these situations in the future.

Regardless of why you owe, you should make arrangements to deal with your unpaid taxes as soon as possible. By being proactive, you can reduce the penalties and interest on your account and avoid facing collection actions. However, in all cases, you should figure out why you owed taxes this year so that you can avoid owing in the future.

Why Do Taxes Exist? Why Do People Pay Taxes?

Governments use tax revenue to create infrastructure, provide healthcare, support military organizations, and pay for other expenses that support their populations. Nearly every country in the world has some sort of tax system - even the 14 countries that don't levy an income tax assess other types of taxes.

Taxes are critical for society to function, but they're also hard to understand. The United States, in particular, has one of the most confusing tax codes in the world, and the situation is made even more complicated by the multiple layers of government in this country.

As a U.S. taxpayer, you may end up paying taxes to the IRS and your state as well as your town and county. You need to understand your tax obligations if you want to avoid unwanted consequences such as civil penalties, involuntary collections, or even criminal charges in cases of tax evasion.

Brief History of Taxation

Taxes are nearly as old as civilization itself. Income tax, property tax, sales tax, and tariffs have all been around for about 5,000 years. In Ancient Egypt, the Pharaoh collected a percentage of all grain harvests. In Ancient Rome, Julius Caesar created the first sales tax and Caesar Augustus implemented an income tax.

In early societies, the rulers could generally levy taxes without any input from their citizens. However, in 1215, the Magna Carta created the then-revolutionary idea that the King couldn't levy new taxes without the consent of the governed. Over 500 years later, this idea played a critical role in fueling the American Revolution as the colonists didn't want to pay taxes without representation.

For decades, the United States' only tax revenue was from tariffs and excise taxes, but to help cover costs related to the Civil War, Congress created the nation's first income tax in 1861. The government repealed this tax about 10 years later. The 1894 Tariff Act created a new income tax law, but the next year, in Pollock v. Farmer's Loan & Trust Co. the Supreme Court ruled that federal income tax on rental income earned from real estate was unconstitutional.

At that time, the Constitution said that Congress could only apply a direct tax if the tax was apportioned based on each state's population. However, it's impractical to apportion income taxes based on state population. In response to this case, Congress proposed the 16th Amendment and ratified it in 1913.

The 16th Amendment states, "Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration."

Occasionally, people try to deny the legitimacy of the U.S. income tax system by making a "constitution-based argument". For example, they may argue that the 16th Amendment lacks an enactment clause or that Congress doesn't have the right to enact taxes. The IRS considers these arguments to be frivolous, and bringing a frivolous argument to the Tax Court can lead to a penalty of up to $25,000. This penalty and the definition of frivolous have been upheld through several legal cases.

How Much Do I Owe? Determining Your Tax Liability

So, how do you figure out how much you owe in tax? There are a lot of different factors that go into that including the type of income, the amount you earn, your filing status, and which credits/deductions you claim. The following sections explain these different elements.

Types of Taxable Income for Individuals

Tax treatment varies based on the type of income. Broadly speaking, you can split most individual income into wages, ordinary income, and capital gains.

Wages are subject to Social Security, Medicare, and potentially income tax and include the following types of income:

Employment income - wages earned from a job as a W2 employee.
Self-employment income earned as a sole proprietor or a partner. This includes 1099 freelance income, money received for selling goods or services online, and income from renting out personal property.
Royalties earned as a self-employed writer, inventor, or artist and royalties earned from an operating oil, gas, or mineral interest.

Ordinary Income is subject to income tax, but not Social Security or Medicare taxes. It includes the following:

Royalties from copyrights, patents, and oil, gas, and mineral properties.
Rent - Most rent earned from investment properties is taxed as ordinary income, but if you receive rent in the course of your business or trade, it's taxed as wages.
Dividends and Interest - All dividends and most interest are taxed as ordinary income, with a few exceptions for non-taxable interest.
Retirement income - Pension Payments and distributions from most retirement accounts are subject to income tax but not Social Security or Medicare. Early distributions before age 59.5 years are generally subject to a 10% penalty in addition to income tax.
Canceled debts - If a creditor cancels more than $600 in debt, they will issue a 1099 for the canceled debt and the amount must be reported on your tax return. However, the debt is not taxable if it was canceled due to bankruptcy, you are insolvent, or the cancellation was a gift.
Corporate income - If you are a shareholder in a C-corporation or an S-corp, your portion of the business's income will be reported on a K-1 form, and it will be taxed as ordinary income. However, if you work for the corporation, you will also receive a W2 reporting your wages.

Capital gains refer to income earned from investments - for example, gains earned from selling stocks or investment property. You can offset your capital gains by capital losses (money lost from selling investments), and you will be taxed on the difference.

That is not an exhaustive list, but it covers the most common types of income. The IRS requires taxpayers to report and pay taxes on everything from lottery winnings to benefits received from trade-and-barter arrangements.

Taxes on Wages

You must pay Social Security premiums, Medicare contributions, and potentially income tax on employment income. As of 2024, the Social Security tax rate is 6.2% on income up to $168,600 and the Medicare rate is 1.45% on all income. If you have an employer, they will withhold these payments from your wages, and they will also make a matching payment.

If you are self-employed, you will pay both the employee and the employer's portion of these taxes, meaning the effective self-employment tax rate is 15.3%. For example, if your employer pays you $1,000, they will withhold $76.50 in Medicare and SS from your wages. Then, they will make a matching payment of $76.50. However, if you're self-employed and earn $1,000, you will pay the entire $153 payment for SS and Medicare taxes.

There is an additional Medicare tax of 0.9% that applies to wages over $250,000 if you're married filing jointly, over $125,000 for married couples filing separately, and over $200,000 for all other taxpayers. Then, on top of all of these amounts, you may also have to pay income tax on your wages. Keep reading to learn how that works.

Income Tax Rates

When you file an income tax return, you report all of your income. Then to calculate your taxable income, you subtract the standard deduction or an itemized deduction. Most people claim the standard deduction, but if the total of your itemizable deductions (mortgage interest, healthcare expenses above a certain percentage of your income, up to $10,000 in state and local taxes, etc.) exceeds the standard deduction, you will claim that amount.

As of tax year 2024, the standard deduction is $14,600 for single and married filing separately, $29,200 for married filing jointly and qualifying widowers, and $21,900 for head of household. Quick example, let's say you are a single filer who earned $40,000 from your job. You will pay Social Security tax (6.2%) and Medicare (1.45%) on all of those wages, but you will only pay income tax on the $25,400 that exceeds the standard deduction for your filing threshold.

What is the federal income tax rate? Income under the standard or itemized deduction is not taxable. Over that amount, income is taxed at a rate of 10 to 37%. Taxpayers don't pay the same rate on all of their income. Rather, they pay 10% on the first part of their earnings. Then, they pay 12% on earnings over a certain threshold, and the rate continues to go up as their taxable income goes up.

As of tax year, 2024, single filers and married couples filing jointly will face the following tax rates on their taxable income:

10% on $11,600 or less ($23,200 for married couples filing jointly).
12% for incomes over $11,600 ($23,200 for married couples filing jointly)
22% for incomes over $47,150 ($94,300 for married couples filing jointly)
24% for incomes over $100,525 ($201,050 for married couples filing jointly)
32% for incomes over $191,950 ($383,900 for married couples filing jointly)
35% for incomes over $243,725 ($487,450 for married couples filing jointly)
37% on income over $609,350 ($731,200 for married couples filing jointly)

To give you an example of how it works, imagine that you're a single filer with $114,600 in income. After you subtract the standard deduction of $14,600, you are left with $100,000 in taxable income. All of the income over $47,150 is taxed at 22% so you pay 22% income tax on $52,850 of income. Your taxable income between $11,600 and $47,150 is taxed at 12%, and finally, the first $11,600 is taxed at a rate of just 10%.

Capital Gains Taxes

If you hold an asset for less than one year, the gains are classified as short-term and taxed as ordinary income, but if you hold an asset for one year or longer, the gains are long-term and taxed at 0, 15, or 20%.

As of 2024, the capital gains tax rate is 0% if your taxable income is $44,625 for single and married filing separately, $89,250 for married filing jointly and qualifying surviving spouse, and $59,750 for head of household. If your income is above those thresholds, the long-term capital gains tax rate is 15%. The 20% rate applies if your taxable income is over $553,850 for married filing jointly or over $492,300 if you're single.

Deductions and Tax Credits

Deductions reduce your taxable income, and tax credits lower your tax liability. As noted above, you claim either the standard deduction or an itemized deduction on your tax return. On top of that, you can also claim a deduction for making contributions to qualifying retirement accounts such as 401k's or Traditional IRAs. Note that deductions reduce your taxable income, but they don't reduce the amount of your wages subject to Social Security or Medicare Tax.

Non-refundable credits reduce your tax bill, but they cannot create a tax refund. Refundable credits, in contrast, reduce your tax bill and can also create a refund. The IRS offers credits for qualifying children, other dependents, daycare expenses, qualifying education expenses, and certain types of energy-efficient home upgrades.

One of the most significant tax credits is the earned income tax credit (EITC) - as of 2024, this refundable credit is worth up to $7,430 for families with three or more children. To claim the credit, your income must be under a certain level, and you cannot have more than $11,000 in investment income.

What About State Taxes?

In addition to federal taxes, you must pay state income tax unless you live in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, or Wyoming. In New Hampshire, you only have to pay state income tax on dividend and interest income, and in Washington State, you're only taxed on capital gains income at the state level.

The other 41 states tax all types of income. Some like New York have tax brackets that work similarly to the IRS's brackets. Others like Colorado have a flat tax that applies to all of your income regardless of whether it's investment income or earned income. Many states tax capital gains and earned income at different rates.

Sometimes, you may end up owing state taxes but not federal. If you're wondering, why do I owe state taxes, look at the tax code in your state or reach out to a tax professional based in your state for help.

Note that you generally must file a state tax return if you live in a state with state income tax. However, you may also need to file a state return if you received income sourced from a state, even if you didn't live there. Some taxpayers must file multiple state returns in addition to their federal tax returns.

Why Do I Owe on My Tax Return? Common Reasons for Owing

Here are some of the most common reasons people end up with an unexpected tax liability when they file their returns, along with tips on how to avoid these situations the next time you file:

Underwithholding from paychecks - If your employer doesn't withhold enough tax from your wages, you will end up owing tax. To avoid owing next year, fill out a new W4 form and make sure that you do the calculations for income from a second job or a spouse. Note that if you don't have enough withheld, the IRS's Withholding Compliance (WHC) system may notice, and if so, the IRS will send a Lock-In Letter to your employer telling them to withhold more from your paycheck. Ideally, you want to avoid this situation by having the right amounts withheld from your paycheck.
Freelance income - People often face an unexpected tax liability the first year they earn freelance income. For example, someone may start driving for a rideshare company to earn extra money without realizing that they have to pay self-employment tax and income tax on their earnings. To avoid owing next year, set aside about 25% of your freelance income (more if you're a high-wage earner) and send estimated income tax payments to the IRS every quarter.
Not paying enough in quarterly estimated tax - If you're self-employed, you must pay quarterly estimated taxes if you owe more than $1,000 in tax for the year. If your quarterly payments aren't enough to cover your tax liability, you will end up owing. You will also incur a penalty if you don't pay at least 100% of your tax for the current year or 90% of the tax owed for the previous year. To avoid owing, don't base your quarterly payments on last year's tax liability. Instead, use IRS Form 1040-ES to calculate your payments based on your earnings every quarter.
Changes in personal situations - Your marital status, number of dependents, and where you live can all impact your tax liability. For example, if you recently got divorced, you will have a lower standard deduction as a single filer. Once your child turns 17, you won't be able to claim a child tax credit for them. If you move to a different state, you will face different state taxes. Any time your personal situation changes, update your W4 or if you're self-employed, consult with a CPA about how to make adjustments to your estimated tax payments.
Receiving income not subject to withholding - Self-employment income, investment income, interest income, rental income, and IRA distributions are generally not subject to withholding. If you receive this type of income, you may end up with an unexpected tax liability. If it's a one-off situation, for example, you cashed out your IRA or sold a bunch of stocks, you don't have to worry about how it's going to affect your taxes in future years. However, if you're going to be dealing with this type of income regularly, you should plan ahead for the tax liability. You can use the IRS's tax brackets to estimate your tax liability or talk with a tax preparer so you know what to expect.
Changes in tax credits - Tax deductions and credits change regularly and can have a significant impact on how much you owe. For example, in 2021, the child tax credit was $3,000 for kids under age 18 and $3,600 for kids under age six. In 2022, it was $2,000 for children under age 17. To avoid unexpected tax liabilities related to changes in the tax code, consider working with a professional tax preparer who can help you with tax planning.

If you have an unexpected tax liability when you file your tax returns, that's a sign that you need to focus more on tax planning. Most employees can easily fix the situation by submitting a new W4 to their employer. If you have business income, investment income, or other types of income not subject to withholding, you should consult with a tax pro about how to plan ahead for your tax liability.

Penalties and Consequences of Unpaid Taxes

If you cannot pay your tax liability, you will incur a failure-to-pay penalty, and the IRS will assess interest on your tax due. The late payment penalty is 0.5% of your unpaid balance every month. It increases to 1% if you don't pay after receiving several notices. However, if you set up a payment plan, the IRS will drop this penalty to .25% per month.

When a tax return shows a tax bill that you cannot afford to pay, many people are tempted to just not file. However, you should not do this. The penalty for not filing is 10 times higher than the penalty for paying late, and these penalties stack on top of each other. To protect yourself financially, consult with a tax pro to ensure that you filed your tax return correctly.

Then, if you really owe taxes that you cannot afford to pay in full, contact the IRS to request a payment plan. If you cannot afford payments, look into an offer in compromise or currently not collectible status.

If you don't pay your taxes at all, the IRS can issue tax liens, garnish your wages, and seize your assets. The consequences vary based on how much you owe. The IRS has 10 years from the later of the filing deadline or the date you file to collect unpaid taxes. Your state can also take collection actions against you if you have unpaid state taxes.

How to Manage and Reduce Tax Liability

As explained above, if you're an employee, you should make sure that you file an updated W4 every year. Don't just note your filing status and number of dependents. Instead, take the time to do the calculations that take into account your other income sources and your spouse's income.

If you run a business, track your income and expenses very carefully, and consult with a tax pro to ensure that you are optimizing your tax situation. Your business structure, retirement contributions, and multiple other factors can affect your tax liability.

Get Help With Unpaid Tax and Tax Planning

Are you facing unpaid taxes? Are you trying to figure out how much you owe? Have other questions about unpaid taxes? Then, reach out to a tax pro who specializes in tax debt resolution and tax problems.

They can help you make payment arrangements with the IRS, and if applicable, they can even review your tax return to ensure it was filed correctly. Then, they can help you plan for future years so that you don't end up owing taxes. Use TaxCure to search for a tax pro today.

Resources:

https://en.wikipedia.org/wiki/History_of_taxation_in_the_United_States

https://www.irs.gov/privacy-disclosure/the-truth-about-frivolous-tax-arguments-section-iii

https://www.irs.gov/taxtopics/tc560

https://www.ssa.gov/oact/cola/cbb.html

https://www.irs.gov/publications/p525#en_US_2023_publink1000229284

https://www.irs.gov/filing/taxable-income

https://www.irs.gov/taxtopics/tc409

https://www.irs.gov/publications/p525#en_US_2023_publink1000229366

https://www.irs.gov/taxtopics/tc403

https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024

https://taxfoundation.org/data/all/state/state-income-tax-rates-2024/